Sen. Elizabeth Warren, D-Mass., is claiming that a buildup in leveraged loans is threatening the economy in the way subprime loans did leading up to the financial crisis.
She criticized the Federal Reserve for "dropping the ball" then and said the same situation is unfolding now, CNBC reported.
Warren highlighted the same concerns in a letter sent to regulators Wednesday in which she expressed concerns about underwriting standards in the leveraged loan market, which she says could pose serious risks to the economy, Reuters explained.
In the letter, Warren questioned regulators on what their agencies’ plans are to address what she describes as “growing risks” in the leveraged lending market as well as proposed changes to rules governing the Collateralized Loan Obligation (CLO) market, the largest buyers of leveraged loans. She requested responses by December 11, Reuters reported.
“I am concerned that the large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market,” Warren wrote.
“These loans are generally poorly underwritten and include few protections for lenders and investors,” she wrote. “Many of the loans are securitized and sold to investors, spreading the risk of default throughout the system and allowing the loan originators to pass the risk of poor underwriting on to investors.”
The $1.1 trillion leveraged loan market, which finances companies including American Airlines and retailer Party City, has been flooded with aggressive deals featuring high debt levels and loose terms, just five years after regulators criticized those same features, concerned about the risks the debt posed to the financial system.
In the letter addressed to Treasury Secretary Steven Mnuchin, Joseph Otting, the Comptroller of the Currency, Jerome Powell, chairman of the Federal Reserve (Fed), Jay Clayton, chairman of the Securities and Exchange Commission, and Chair Jelena McWilliams of the Federal Deposit Insurance Corp, Warren noted the growth of the market and the increase of debt that lack full lender protections, known as covenant-lite loans.
A potential presidential candidate, Warren made stern comments directed at Fed Vice Chairman Randal Quarles during a hearing Thursday.
Warren said she thinks the Federal Reserve and its fellow watchdogs of the financial system are overlooking a dangerous buildup of loans going to companies that are already deeply in debt.
In a face-to-face hearing with Quarles, vice chairman of supervision and thus the central bank's leading bank regulator, Warren said she is worried about a lack of oversight.
"I'm not sure that I see much distinction between what you're doing now and what the Fed was doing in pre-2008, and I think that's deeply worrisome," she said. "I'm very concerned that the Fed dropped the ball before and they may be dropping it one more time," she was quoted by CNBC as saying.
The Fed will look carefully at leveraged lending during this supervisory cycle as well as how the CLO market is evolving, Quarles said, but noted that the guidance is not enforceable.
More than $585 billion of U.S. institutional loans were arranged in the first three quarters of the year after a record $923.8 billion was issued in all of 2017, according to LPC data. In 2007, at the height of the pre-crisis buyout market, $425.8 billion of institutional loans were arranged.
Leverage for buyouts increased to 6.94 times in the third quarter, the highest level since the same three-month period in 2014, according to the data. About 73% of the leveraged institutional market in the first nine months of 2018 was covenant-lite.
Warren highlighted the floating-rate nature of the debt – a selling point for investors looking for a hedge to rising interest rates – and noted that additional rate hikes by the Fed could force companies to deal with rising interest costs as the economy slows down.
The Fed has raised rates eight times in the last three years.
Warren’s comments follow those from former Fed Chair Janet Yellen, who said in a Financial Times interview that lending standards were falling. The Bank of England’s Financial Policy Committee has also sounded the alarm about the asset class.
Warren posed questions to each of the receivers, asking what the Financial Stability Oversight Council (FSOC) is doing to monitor the leveraged loan market and how regulators viewed requests to loosen the Volcker Rule for CLOs.
She also asked if the Office of Credit Ratings had found any evidence that leveraged loan and CLO ratings lack accuracy or are “unduly influenced” by conflicts of interest.
“I am concerned about the rapid growth of leveraged corporate lending and the lack of appropriate response from the Financial Stability Oversight Council (FSOC) and your individual agencies,” Warren wrote. “I fear that continued growth in leveraged lending – along with the steady degradation in loan terms – creates significant risk to the financial system and the American economy.”
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