The steady drumbeat of warnings over the surge in risky corporate borrowing is growing louder and louder. Time and again, regulators in the U.S. and Europe have pointed to the hazards of businesses taking on too much debt.
At issue is the $1.3 trillion leveraged lending market, composed of high-yield loans from firms with some of the weakest finances. While Federal Reserve and European Central Bank officials have drawn attention to these heavily indebted companies and the deteriorating standards of loans bundled into securities called CLOs, most regulators are careful to say a repeat of 2008 is unlikely because investors, rather than the banks they oversee, hold most of the debt.
Yet that’s created a new, and potentially more dangerous, kind of risk. Precisely because roughly 85% of leveraged loans are held by non-banks, regulators are largely in the dark when it comes to pinpointing where the risks lie and how they’ll ripple through the financial system when the economy turns. More and more, critics are questioning whether regulators like the Fed have a handle on the problem or the right tools to contain the fallout. A big worry is highly indebted businesses employing thousands could face severe financial stress and, in some cases, insolvency, deepening the next downturn.
“I always remind myself that even the smartest policy maker with the most far-reaching perspective, data and tools was basically blind-sided by the breadth and depth of the housing crisis,” said Mark Spindel, chief investment officer at Potomac River Capital. “Leveraged loans and corporate debt are not housing, but maybe it’s more pervasive than we think. We can’t take any of the CLO, leveraged loan, or private debt growth for granted.”
Signs of excessive risk-taking have emerged in any number of markets. But leveraged lending has raised eyebrows partly because of how lightly it’s regulated. Fueled in large part by demand from collateralized loan obligations that offer interest rates that approach 9% on some riskier portions of the debt, the market for leveraged loans has more than doubled since 2012.
One of the ironies of the boom is that much of the risk-taking decried by central banks and regulators is largely of their own making.
Years of ultra-low rates have made it easier than ever for less-creditworthy companies to borrow large sums of money, all while pushing investors toward riskier investments. At the same time, post-crisis bank regulations have fueled the rise of shadow lenders, which helped facilitate the growth of leveraged lending. Then, financial watchdogs appointed by the Trump administration started encouraging Wall Street to dial-up more risk last year by easing guidelines to limit lending to deeply indebted companies, which freed banks to compete more directly with non-bank firms to underwrite the riskiest loans.
And now, with U.S. interest-rate cuts back on the table, the Fed may end up fueling even more of the high-risk lending that they’ve tried to rein in. A Fed representative didn’t immediately respond to a request for comment.
“Whenever you give children toys, you know they’re going to keep playing with them until they break them,” said Phil Milburn, a fund manager at Liontrust Asset Management in Edinburgh, Scotland. “Someone has to come into the room and say put your toys down.”
Corporate indebtedness is already running high. By one measure, U.S. companies have 7.7 times as much debt as they generate in annual earnings, according to research firm Covenant Review, which looked at debt-to-unadjusted Ebitda ratios in the first quarter for firms involved in acquisitions and buyouts. That’s near a post-crisis high. Four years ago, the debt-to-Ebitda ratio was just 5.5. European deals aren’t far behind.
The risk-taking could get worse: With sales of leveraged loans declining this year, many companies have been able to extract looser terms. Protections in loan documents to shield creditors from defaults are some of the weakest ever, according to Moody’s Investors Service. And lenders, however grudgingly, have begun to accept more aggressive projections of future cost savings and profits, which may never materialize.
As a result, regulators globally are once again talking more and more about the hazards of leveraged lending and CLOs, and warning of the excesses they helped unleash.
In recent months, both Fed Chair Jerome Powell and Bank of England Governor Mark Carney have compared some aspects of the growth in leveraged lending to the mortgage industry in the run-up to the subprime crisis. And while neither said the risks pose a large enough threat to topple the financial system (largely because the exposure isn’t concentrated in a few big banks), both concede there’s a lot regulators just don’t know, like who the buyers are and how well they can absorb losses.
Wells Fargo research suggests buyers of CLOs include U.S. banks, insurers and hedge funds, as well as a large number of non-U.S. financial firms. Japanese banks including Norinchukin, which invests the savings of farmers and fisherman, are among the biggest buyers of the highest-rated tranches as they face zero or even negative returns on the country’s own bonds.
Some say regulators aren’t doing nearly enough to fix their blind spots.
“I am not confident that regulators have or share among themselves the high-quality information that they need,” Erik F. Gerding, who specializes in financial regulation at University of Colorado Law School, said at a congressional hearing on leveraged loans on June 4. “We cannot wait until it is time to man the lifeboats to fully fund the iceberg patrol.”
Regulators also risk making a mistake if they dismiss just how important banks are in all phases of leveraged lending, according to Gaurav Vasisht, director of financial regulation at the Volcker Alliance, a non-profit good governance group. Not only do they underwrite the loans, they also sell the loans to the CLOs that the debt is bundled into, invest in the securities and then hedge those risks in the market.
“We don’t fully understand or appreciate the role that banks place in this market,” he said at the hearing. “One common narrative is that banks don’t have much risk or aren’t exposed to it -- (but) banks are exposed to it.”
For their part, the industry titans presiding over this ever-growing pile of debt are eager not to sound complacent. Brian Moynihan, CEO of Bank of America, the leading arranger of high-risk corporate loans, predicted last week that some highly leveraged companies could face “carnage” if the economy slows and they can’t keep up on their debt payments. Pimco, the world’s largest bond investor, said last month the credit market is “probably the riskiest ever.”
A few cracks are already starting to show. Take for example, France’s Rallye SA, whose chairman Jean-Charles Naouri controls supermarket chain Casino Guichard-Perrachon SA through a series of debt-laden holding companies. Rallye, which racked up 2.9 billion euros ($3.3 billion) of loans and bonds, for years used Casino’s dividends to pay lenders and pledged shares to secure credit lines, until it filed for creditor protection last month.
When the credit cycle finally does turn, UBS estimates investors in junk bonds and leveraged loans could lose almost a half-trillion dollars, more than any downturn since at least 1987.
Nevertheless, many debt investors and dealmakers are focused just as much on the opportunity as the risk, and downplayed the dangers of the leveraged loan market to the broader economy.
Marc Lasry, founder of Avenue Capital, said in March that a “slowdown is great” for credit because it will lead to a slew of bargains. For BlueBay Asset Management, current economic conditions amount to a “Goldilocks” moment. Defaults remain low, but growth isn’t strong enough to compel central banks to tighten policy. Low defaults are a reason Elliot Ganz, general counsel to loan industry group LSTA, doesn’t foresee significant disruptions in the loan market. He says the risks in leveraged lending will most likely be contained and that there’s little reason to believe it’s a systemic risk.
“Will investors take losses? Absolutely -- but that’s what they get paid for,” he said. However, “banks are not going to be as exposed as they were in 2007.”
Just because the banks are safer doesn’t necessarily mean the financial system is, says Karen Petrou, managing partner at Federal Financial Analytics, a regulatory-analysis firm. Debt investors might not be as resilient in a crisis and create shock waves throughout the system.
“Banking regulators are being a little myopic when they’re looking only at the banking system for systemic risk,” she said. “That’s the fundamental missing point that I have seen the banking agencies are over-sanguine about.”
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