There have been several high profile warnings from regulators about the potential for leveraged loans to trigger the next financial crisis. In the past week leveraged loans have fallen to a two year low, the first indication of trouble brewing in the leveraged loan market. There is a concern in relation to a rise in credit downgrades and subsequent forced sales of assets into an illiquid market. A combination of slower economic growth and a decline in market demand for new loans will result in less refinancing and a likely uptick in corporate defaults. The Fed has said that it is taking a “closer look” at whether Wall Street banks are chasing deals without adequately protecting themselves against losses. Given the size of the market at an estimated $1.3trn, regulators remain uneasy as to how losses and a credit squeeze will trickle through the wider economy and its knock-on impact onto the financial system. This article accesses the main concerns of regulators and rating agencies and looks at a possible trigger which could cause a sub-prime like crisis.

Leverage Loans are on the Regulators Radar!

The IMF in its blog on the 15th of November 2018 reiterated its concerns on the dangers inherent in the leverage loan market. This follows the warnings outlined in its October Global Financial Stability Report where it commented that non–financial sector leverage constitutes a medium-term financial stability risk. The IMF believes that “Although the global banking system is stronger than before the crisis, it is exposed to highly indebted borrowers as well as to opaque and illiquid assets and foreign currency rollover risks.” They call on policymakers to urgently step up efforts to boost the financial system’s resilience by completing the financial regulatory reform agenda as well as developing and deploying macro-prudential policy tools.

At the end of October, the Federal Reserve warned on the risks involved in leveraged lending as banks chase riskier deals, without adequately protecting themselves against losses. The head of risk surveillance and data at the Fed expressed a concern that “There may be a material loosening of terms and weaknesses in risk management.” The remarks were spurred by emerging trends that he said could threaten the safety and soundness of the biggest banks. The main areas of concern for the Fed include the growth in covenant-lite loans, which offer fewer safeguards for lenders as well as the increased use of “collateral stripping,” in which borrowers move collateral out of reach of creditors. Indeed discussions at September Federal Open Market Committee noted “the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the non-bank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability.”

The Bank of England‘s latest Financial Policy Committee statement from October states that the Committee “is concerned by the rapid growth of leveraged lending, including to UK businesses.” It further adds that “The global leveraged loan market is larger than – and growing as quickly as – the US subprime mortgage market was in 2006”.  It recognises, however, that “there are important differences between these two markets, for example with less reliance now on short-term wholesale funding.” The Bank of England estimates that high yield bonds and leveraged loans, taken together, account for about 20% of total UK corporate sector debt.

“Leveraged loans are typically sold to non-bank investors (including to collateralised loan obligation funds), whose ability to sustain losses without materially impacting financing conditions is uncertain. However, banks retain some exposure and make other loans to the same highly indebted companies. The FPC is therefore assessing the implications of the rapid growth of leveraged lending for both non-banks and banks.”

The BIS in its September Quarterly Review notes that “Leveraged finance, comprising high-yield bond and leveraged loan-based finance, has doubled in size since the Great Financial Crisis (GFC)”. It notes that investor demand has been an important driver of growth and “this is evident from investors’ continuing willingness to accept weaker protection against deterioration in borrowers’ repayment capacity. Specifically, the fraction of covenant-lite loans reached its post-GFC peak in late 2017, while the average number of covenants per loan with covenants has decreased by 25%”.

The BIS report states investors in leveraged loans are “not necessarily being compensated for this risk”.

The BIS analysis also concludes that originator banks are finding it easier to securitise and sell these loans as evidenced by the purchases of these loans by Collateralised Loan Obligations (CLOs), especially in the last couple of years. The reversal of the post-GFC reforms mandating US issuers to retain a minimum retention requirement of 5% of issued securitisations on their balance sheet was reversed by a February 2018 court ruling which has resulted in increased demand for loans.

Developments in the securitisation market have also contributed to the growth in leveraged loans. Originator banks are finding it easier to securitise and sell these

The ECB commented on the market in its May 2018 Financial Stability Review that high investor demand has allowed increasingly leveraged corporates to obtain financing in the leveraged loan market. In the US, corporate leverage for firms active in the leveraged loan market has already exceeded pre-crisis peaks and the same trend has been observed for first-lien corporate leverage in the European market. In many cases, actual leverage is likely to be significantly higher than reported leverage, given the increasingly common practice among borrowers of making optimistic adjustments to Pro-forma EBITDA levels.

In both Europe and the US, the ECB believes that the level of investor protection envisaged in leveraged loan contracts is low, covenant-lite transactions are now reported to account for around 80% of the issuance in both markets, compared to less than a quarter during the pre-crisis period. Since investors have fewer means of timely intervention to restrict borrower behaviour, this increases the likelihood that defaults will be delayed and recovery rates will be lower. Borrower bargaining power has also led to other forms of weakened investor protection, such as restrictions on loan transferability in the secondary market and limits on the share of the issuance that can be held by any one investor.

In the EU, non-bank investors have increasingly replaced banks in the financing of highly indebted companies. Since the financial crisis, banks have reduced their share of financing in the primary market, with non-bank investors estimated to have provided more than half of the overall financing in 2017. This reflects both very high investor demand, as investors have increasingly purchased term loans and even bank facilities traditionally retained by banks, and banks have faced higher capital charges and other regulatory restrictions.

The ECB states starkly that “Developments in leveraged loan markets may create financial stability risks. In particular, the rollover of maturing loans into exposures with a significantly worse risk-return profile may create vulnerabilities. In addition, the distribution of risks beyond the banking sector is unknown, given the lack of statistical data. Finally, higher than expected potential losses in this sector may spill over to the wider economy.” With these risks in mind, the ECB issued guidelines on leveraged transactions in May 2017 which set minimum supervisory expectations regarding loan origination, loan identification and the leveraged lending risk control framework for the banks under its remit.30 In this context, all relevant credit institutions should be in a position to demonstrate how their loan origination and risk management practices reflect the ECB’s expectations by November 2018.

How Big is the Potential Problem

In the past six years, the leveraged loan market size has doubled in size to $1.3trn, according to the IMF.

They estimate that as a share of new corporate issuance in the United States, highly-leveraged loan deals with debt least 5 times EBITA makes up roughly 50% of total corporate issuance, in Europe, the ratio is even higher, at approximately 60%.

The UK, in particular, has witnessed a dramatic surge. According to the Bank of England, gross issuance of leveraged loans reached a record level of £38bn in 2017, with an additional £30bn issued so far this year. When combined with high-yield bonds, the stock of risky lending to UK firms has more than doubled since the crisis, per the BoE:

In April 2018 Standard & Poor’s as reported in the FT, warned of the risks in leveraged loans as weak lending terms pose a risk as the credit cycle approaches a peak and deal-making has surged in recent months., S&P warned that leverage was approaching or exceeding levels seen before the financial crisis in the US and Europe and that companies and private equity firms were willing to pay more to clinch deals than at any time since at least 2003 in the US.

S&P analyst, Paul Draffin, said: “History shows us that the worst debt transactions are done at the best of times . . . Now is the perfect time to be cautious.”

Credit Quality

According to Moody’sroughly 80% of US leveraged loans in the first quarter were considered “covenant-lite,” compared with less than 25% in 2006 and 2007. To gauge covenant quality, Moody’s tracks numerous metrics, including leverage requirements and the seniority of lenders’ claims, and then scores the average strength on a scale of 1 to 5. The higher the number, the weaker the covenant. The indicator now sits at 4.12, the weakest on record.

What could trigger the sell-off?

However, the loan default rate will soar once core profits inevitably contract amid a troubled business outlook that triggers a credit crunch. The two cycle peaks of the high-yield loan default are the 12.16% of November 2009 and the 7.73% of June 2002.

According to Bloomberg US leveraged loans prices dropped to a two-year low (16th November 2018) as credit and equity markets slumped. The decline was prompted by “negative vibes from the junk bond market” and “an increase in supply as issuers piled in to capitalize on robust demand for floating-rate assets.” The report states that “concerns about peak earnings, trade wars, oil prices and rising rates are all knocking credit, which had its worst October since 2008 and continued to sell off this month.”

The BIS remains uneasy with CLO’s and mutual funds which have become major buyers of leveraged loans. They have stated that BBB borrowers, which in a downturn would be downgraded to a BB or lower rating could force certain investors, mandated to invest in investment-grade debt, to sell loans regardless of price in a “fire sale”. The BIS cautions that:

The relative illiquidity of leveraged loan markets could exacerbate the resulting price impact. Moreover, given that mutual funds are a major buyer, mark-to-market losses could spur fund redemptions, induce fire sales and further depress prices. These dynamics may affect not only investors holding these loans, but also the broader economy by blocking the flow of funds to the leveraged credit market.

There are concerns that the recent decline in leveraged loan prices is the first indication of trouble brewing in the leveraged loan market. There are real concerns that potential downgrades to loans may result in significant downward pressure on prices, as credit rating constrained investors are forced to sell bonds into an illiquid market, causing further distress. A combination of a slowing economy and a decline in market demand for new loans will result in less refinancing and a likely uptick in corporate defaults in a product which has minimal levels of borrower protection. Given the size of the market at an estimated $1.3trn, regulators remain uneasy as to how losses and a credit squeeze will trickle through the wider economy and what its knock-on impact onto the financial system will be.