NEW YORK, June 3 (LPC) - A Congressional committee will discuss risks in the US$1.2trn leveraged loan market at a hearing this week as loosening lender protections and aggressive terms in the asset class have drawn the ire of lawmakers and regulators.
A subcommittee of the US House Financial Services Committee will hold the hearing titled “Emerging Threats to Stability: Concerning the Systemic Risk of Leveraged Lending” on Tuesday at 2 p.m., Congresswoman Maxine Waters, chair of the committee, announced in a May 24 news release.
Years of low interest rates coupled with increasing demand for floating-rate loans has seen the asset class more than double in size, allowing companies to borrow higher levels of debt compared to their earnings than in the past while offering fewer lender protections in return. The aggressive underwriting has drawn rebukes from Senator Elizabeth Warren, former Federal Reserve (Fed) Chair Janet Yellen and Governor of the Bank of England Mark Carney.
But current regulators including Randal Quarles, vice chair for supervision at the Fed, has tried to tamp down on concerns that the leveraged loan market could present a systemic risk.
This hearing is “obviously sending a strong message and removing plausible deniability by the regulators if this were to become a systemic issue,” said Lee Reiners, executive director of the Global Financial Markets Center at Duke Law School and a former examiner at the Federal Reserve Bank of New York.
Erik Gerding, a professor of law at the University of Colorado Law School, Victoria Ivashina, a professor of finance at Harvard Business School, Gaurav Vasisht, director of financial regulation initiatives at The Volcker Alliance, and Gregory Nini, assistant professor of finance at Drexel University, are scheduled to appear at the hearing.
“The hearing will provide the committee an opportunity to review what is known about leveraged lending, the tools available to regulators to identify and mitigate risks to the US economy and financial stability, recent regulatory actions and potential legislative proposals,” according to a May 30 Financial Services Committee memo.
Congressman Gregory Meeks, who chairs the Subcommittee on Consumer Protection and Financial Institutions, which is overseeing the hearing, has previously questioned regulators about leveraged lending, most recently Quarles during a May 16 regulatory oversight hearing.
The Fed official said that while Collateralized Loan Obligations (CLOs), the largest buyers of leveraged loans, and the underlying asset class may present a credit risk, he does not view them as a broader risk to the stability of the US economy.
“A repricing of those assets could have a magnifying effect on a business downturn; we don’t think that will turn into a financial stability problem,” Quarles told Meeks. “But if these assets were to reprice substantially given the increase of volume there has been of them, the investors in them would lose money, clearly, and that could exacerbate a business downturn.”
The Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp updated leveraged lending guidance in 2013, worried about weakening underwriting standards. They described loans without a full package of covenants as aggressive and expressed concerns about leverage of more than 6.0 times.
Six years later and debt compared to earnings at companies has soared with leverage for buyouts rising to an average of 6.96 times in the first quarter, up from 5.8 times in the first three months of 2013, according to LPC, a unit of Refinitiv, data.
At the same time, almost 75% of broadly syndicated loans arranged in the first quarter was covenant-lite compared to 58.9% of loans issued in the same period in 2013, according to the data.
Aggressive underwriting and more loan-only deals that lack a high-yield bond component to take some of the loss indicate lower recoveries in the next downturn, according to Christina Padgett, a senior vice president at Moody’s Investors Service.
First-lien loans are forecast to recover about 61%, compared to the average historical recovery of 77%, according to Moody’s data. Recoveries for second-lien loans are forecast to be just 14%, down from the average historical rate of 43%.
The Loan Syndications and Trading Association (LSTA) encourages this type of discourse and analysis of risk in the market, Elliot Ganz, general counsel at the US loan trade group, said in a telephone interview.
“This is an appropriate use of a hearing,” he said. “We’ve done a lot of research on this very issue and parsed out the various components of risk, namely the difference between credit risk and systemic risk.”
While the possibility of losing money due to individual corporate defaults exists, the LSTA does not think leveraged loans pose a systemic risk.
The 2019 market differs from its 2007 counterpart because this time there are no mark-to-market CLOs that are sensitive to market fluctuations, which removes a forced seller, Ganz said. The pipeline of underwritten loans sitting on banks’ balance sheets is also significantly smaller than before the financial crisis.
“So, if the music, so to speak, stopped,” Ganz said, banks “would not be forced sellers into the market, putting pressure on prices.” (Reporting by Kristen Huanss. Editing by Michelle Sierra and Jon Methven)