US officials say they will investigate the risky $1.6 trillion 'leveraged loan' market
- The US Financial Stability Board will launch an inquiry into the risky leveraged loan market, the Financial Times reported.
- Leveraged loan volume has spiked in recent years, leading to warnings from former Federal Reserve Chair Janet Yellen and the Bank of England.
- "The deterioration in underwriting standards for leveraged loans is increasingly worrisome," says Lazard Asset Management.
The Financial Stability Board (FSB) said it will investigate the growing leveraged loan industry.The $1.6 trillion market has recently seen lending to companies with lower credit ratings occur at much greater levels than previously, leading to a proposed review later this year, FSB Chairman Randal Quarles told the Financial Times.
Leveraged loans are often used by private equity groups in leveraged buyouts (LBOs), or by troubled companies who are locked out of better-quality credit markets, forcing them to borrow at high multiples of their earnings. The "leverage" aspect suggests that such loans are a bet on the future of the company.
Referring to financial stability, Quarles told the FT that "we need to know more about that than we do and we have set up a process at the FSB to understand that."
The FT wrote: "Regulators could act if their findings point to actual hazards in the market for leveraged loans."
A decade on the from the financial crisis, regulators are looking at potential risks to global systems. Rocketing corporate debt has become a major concern, as "leveraged" lending has boomed.Former Federal Reserve Chair Janet Yellen, the Bank of England, the Reserve Bank of Australia, and current Fed Chairman Jerome Powell have all warned of the dangers of excess levels of leverage. The outstanding total of the instruments are estimated to be between $1.4 and 1.6 trillion. The total of leveraged loan new issuance was over $700 billion in 2018.
"The deterioration in underwriting standards for leveraged loans is increasingly worrisome," Ron Temple, Co-Head of Multi-Asset and Head of US Equity at Lazard Asset Management, said in an email to Business Insider. The combination of increasing leverage, even with generous accounting, and decreasing covenant protection "should be a warning sign to investors. As we assess the global credit landscape, this segment appears susceptible to disruption in the event of a downturn."
The abundance of leveraged lending in recent years has also coincided with a deterioration the quality of covenants, or legal protections for lenders, leading to additional concerns about the product's durability in the event of an economic downturn.
The loans are sold in packages (called collateralized loan obligations, or CLOs) to other investors much the same way as mortgages are bundled for people who want the stream of cash flows from a mortgage-debt investment.
CLOs are set to be the focus of the FSB's review, although Quarles told the Financial Times that US banks' exposure to the instrument was not "excessive."