NEW YORK, Feb 22 (LPC) - Regulators are increasingly sounding the alarm about risk held by leveraged loan buyers outside the banking system as years of low interest rates have pushed non-bank lenders toward higher-yielding assets.
The Federal Reserve (Fed), the Financial Stability Board (FSB) and the Bank of England have all sounded the alarm about the growth of non-bank lenders, which include Collateralized Loan Obligations (CLO) and Business Development Companies (BDCs), in the leveraged loan market. A record US$128.1bn of US CLOs, the largest buyers of loans, was issued in 2018, according to LPC Collateral data.
Concerns about the growth of these lenders prompted the FSB this month to suggest that enhanced data and information collection is necessary to have a clearer view of the loan market and its risks, given its complexity and lack of transparency.
Following the credit crisis, as central banks kept rates near or, in some cases, even below zero, investors searching for yield turned to the floating-rate leveraged loan market, betting they would benefit when rates rose. Loans pay lenders a set rate plus Libor, which rises as rates increase. The Fed hiked rates nine times in the last four years.
An influx of cash into CLOs and loan mutual funds, a mainstay in retirement accounts, allowed companies to slash borrowing costs, extend maturities and erase lenders’ protections in documents, which prompted concerns about recovery rates.
“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,” Senator Elizabeth Warren wrote in a November letter to regulators citing concerns about underwriting standards in the leveraged loan market.
US regulators updated existing leveraged lending guidance in 2013, apprehensive by loosening terms, warning that debt compared to earnings, known as leverage, that exceeds 6.0 times “raises concerns,” and that at least 50% of total debt should be able to be repaid within five to seven years.
But the market has been emboldened by calls for deregulation, with President Donald Trump vowing to “dismantle” Dodd-Frank financial regulations.
A record US$923.8bn of US institutional loans was arranged in 2017 followed by US$730.4bn in 2018, according to LPC data. At the same time corporate buyout leverage rose to 6.6 times last year, up from 6.4 times in 2017, while lender protections weakened in the third quarter to a record low, according to Moody’s Investors Service.
“These developments are analogous to the ‘No Doc/No Income’ heyday of US subprime,” Mark Carney, Governor of the Bank of England, said at a Financial Times event this month.
Leverage for Blackstone Group’s purchase of a 55% stake in Thomson Reuters’ Financial & Risk business last year was 7.6 times as of June 30, according to Moody’s. The private equity firm told lenders, including CLOs that bought the debt, that total leverage was just 5.3 times after adjustments. Covenant Review ranked the deal’s covenant package as one of the weakest arranged last year. The F&R business, re-named Refinitiv, owns LPC.
With CLOs and mutual funds owning the lion share of loans, concerns have grown about their potential role in the next credit crisis after loan prices fell more than 4 percent last quarter.
“No one can see a particular trigger but what we experienced in December [came from] uncertainty around policy, rate outlook, questions about a trade war, and that effects investor confidence,” said Ana Arsov, a Moody’s managing director. “When buyers disappear that leads to repricing of risks, which then has a negative effect on asset classes.”
Moody’s in a December 4 presentation predicts first-lien loan recoveries to be just 61% in the next default cycle from the historical average of 77%. Second-lien loans may recover just 14%.
Weighing on portfolios is an increase in the number of borrowers rated B3 or lower, which rose to 192 companies at the end of January, a 3.2% jump from December, which Moody’s says indicated a growing number of companies with an elevated default risk. The B3 rating is six levels above default.
A sharp jump in downgrades may force CLOs to divert payments from their most junior investors because the funds are often capped on the percent of assets they can hold with a Caa rating or lower.
The question of stress in the loan market and its broader impact will even be a panel this month at the SFIG Vegas 2019 structured credit conference. The closed-to-the press panel is titled: Is the loan market the death of securitization?
Supporters of the loan market point to low default rates – just 1.75% at the end of 2018, according to Fitch Ratings – and strong historical CLO performance – just 53 tranches experienced a principal impairment between 1999 and 2016, according to Moody’s – as positives of the asset class.
The Loan Syndications and Trading Association has taken pains to stem criticisms, noting on its website that while credit risk – the possibility of losing money due to individual corporate defaults – exists, it does not think leveraged loans pose a systemic risk, as it is just 4 percent of the fixed-income market.
CLOs have “been tested and proven to work as intended through the cycle,” Barclays’ analysts wrote in a February 15 report. “However, like all investments, there are always complexities that require constant monitoring.” (Reporting by Kristen Haunss Editing by Michelle Sierra and Jon Methven)