March 20, 2020 / 6:09 PM / 19 days ago

US Senator Warren presses FSOC on leveraged loans as debt prices plunge

NEW YORK, March 20 (LPC) - Us Senator Elizabeth Warren has asked for information about leveraged loans as the price of the debt has fallen more than 17% this month amid volatility caused by the spread of the coronavirus, which has closed businesses and led companies to warn investors their earnings could be diminished.

The Democrat from Massachusetts sent a letter Thursday to Treasury Secretary Steven Mnuchin, who serves as chair of the Financial Stability Oversight Council (FSOC), requesting information about the leveraged lending market and the potential risks the debt could pose to the financial system amid the deteriorating economic conditions.

“Now, as we are on the verge of another, potentially deeper, economic crisis, regulators still have not taken meaningful action to mitigate these risks,” Warren wrote.

“If institutional borrowers are unable to repay their loan balances due to hits to their bottom lines, the loans will fail and spread risk to all the entities that are exposed to them, escalating the effects of an economic downturn across many more institutions and millions of already hard-hit families.”

Warren in the letter asked Mnuchin to provide clarity on how FSOC is addressing risk related to leverage lending, including a description of how FSOC is monitoring these risks, as well as provide the group’s assessment of the market’s risk to the financial system and economy as a whole.

She also asked for FSOC’s assessment of risks to individual industries exposed to these loans.

Warren requested a response by April 2.

SUPPLY CHAIN DISRUPTION

Concerns about the fast-spreading virus have sent markets into a frenzy. The LPC 100, a cohort of the 100 most liquid US loans, has dropped more than 17% in March to 80.05 cents on the dollar Thursday, the lowest level since May 2009.

In late January, the World Health Organization (WHO) declared the outbreak a ‘public health emergency of international concern.’ More than 254,900 people globally have been infected with over 10,400 deaths as of Friday, according to data compiled by the Johns Hopkins Center for Systems Science and Engineering.

The virus has interrupted supply chains, closed retail operations, and reduced consumer demand as cities around the world encourage residents to stay home. All these actions are expected to result in lower earnings for businesses, and S&P Global Ratings have said the world economy could be heading toward a recession.

In response, companies including hotel operator Hilton Worldwide and automobile manufacturer Ford Motor Co have drawn down on their revolving lines of credit to ensure they have access to liquidity amid the uncertainty.

SOUND THE ALARM

Warren has been sounding the alarm about the US$1.2trn US leveraged loan market, which companies rely on to finance operations and back mergers and acquisitions, concerned the asset class resembled the pre-2008 subprime mortgage market.

In 2018 she sent a letter to regulators questioning what their agencies plans were to address what she described as “growing risks” in the leveraged lending market as well as proposed changes to rules governing Collateralized Loan Obligation (CLOs), the largest buyers of leveraged loans.

After a quick start to 2020, with companies rushing to the market to reprice their debt, issuance has virtually stopped with at least 14 deals, about US$19.25bn in loans, in the US being pulled since February 28, according to Refinitiv LPC data.

There was just US$406.1bn of institutional US loan issuance in 2019, down from US$730.36bn in 2018. But at the same time, the amount of debt a company has compared to its earnings, known as leverage, jumped. Annual leverage for leveraged buyouts rose to 6.73 times in 2019, the highest level since 2007, when total leverage was 7.05 times, according to the data.

In 2013, when regulators updated leveraged lending guidance, they warned that leverage of more than 6.0 times “raises concerns.”

The leveraged loan default rate in January was 3.7%, up from 1.9% a year earlier, according to Moody’s Investors Service. Recoveries for first-lien loans are forecast to be about 61%, down from the average historical recovery of 77%, according to the ratings firm. Recoveries for second-lien loans are forecast to be just 14%, down from the average historical rate of 43%.

Warren told Mnuchin that underwriting standards in leveraged loans are poor, and there are few protections for lenders. The growth of the asset class and CLO market has spread risk throughout global markets.

“In an economic downturn, these loans can present greater risks to the broader economy,” Warren wrote.

Reporting by Kristen Haunss; Editing by Michelle Sierra

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