Here’s why the Fed and global regulators are sounding the alarm on leveraged loans and CLOs

With each passing month, regulators raise new concerns about the booming market for leveraged loans.

The heightened attention around this obscure corner of the debt markets has reflected concerns that excessive corporate debt in America could serve as a barrel of powder and worsen the economic pain of the next recession.

Yet even if these investments don’t disrupt the U.S. financial system, bank watchdogs, including the Federal Reserve, say the deterioration in underwriting standards in the leveraged loan market could mean that many mortgage holders Leveraged loans will suffer greater losses than they anticipated.

Why are investors worried about leveraged loans?

Leverage loans are variable rate loans made to companies rated below the investment grade, often used to finance mergers and private equity transactions. Their growth has been fueled by the Fed’s rate hike campaign over the past few years, which has raised yields on adjustable rate instruments, and continued demand for richer yielding assets in a rate environment. low interest.

The leveraged loan market has now climbed to around $ 1 trillion, eclipsing its peers in the high yield bond universe. However, inflows have tapered off since late last year, after the Fed said it would pursue a more cautious stance on further rate moves at its January meeting.

Taking advantage of strong demand, underwriters have regularly relaxed investor protections in the form of restrictive covenants, which can take the form of wording prohibiting the company from exceeding certain debt levels or covenants preventing the sale of debt. ‘assets on which creditors rely for collateral.

Rating companies like Moody’s are now claiming that the level of protection offered to buyers of leveraged loans has reached an all-time high. And 80% of leveraged loans fall under the category of restrictive covenants, which means they lack written guarantees for creditors, according to the Bank for International Settlements.

This means that if loans start to default, investors may find that the amount they ultimately recover on their destroyed assets is smaller than they thought. Barclays analysts have estimated collections will fall by around 5-10 cents on the dollar in the next downturn, compared to previous bouts of stress in the loan market.

Who buys them?

Before the financial crisis, loans to heavily indebted companies were mainly the preserve of banks. But now leveraged loans are mostly funded by non-bank lenders such as investment managers and hedge funds, said David Lebovitz, global markets strategist at JP Morgan Asset Management, at a lunchtime event. last Wednesday.

See: ‘It’ll end badly,’ JP Morgan strategist says of mysterious Wall Street debt boom

In particular, leveraged loans have fueled an insatiable hunger among the $ 600 billion secured loan bond (CLO) market, according to data from the Securities Industry and Financial Markets Association.

More than 60% of sub-investment grade loans have been clawed back by such structured products, according to LCD / S&P, a research consultancy that tracks leveraged loans.

CLOs have also gained attention in part because of their similar construction to secured debt securities and other esoteric forms of debt accused of giving rise to the 2008 recession.

CLO managers bundle and repackage loans into a pyramid of fixed rate products, called tranches, and sell them to Wall Street portfolio managers. Owners of the lower strata, such as CLO equity, receive the highest returns, but receive the interest payments from the underlying loans last, and are also the first to absorb the losses if the loans start to make. default. The upper layers, like the triple A rated CLO debt, are the most creditworthy, but they generate only meager returns.

Investors say appetite for leveraged loans among CLO managers has created a race to the bottom, lowering the quality of underwriting standards and increasing the risk that ultimate leveraged loan holders face heavy losses if business credit markets sell out.

“The high demand for leveraged loans, driven by the increase in institutional investors, especially CLOs, is responsible for the decline in the protection of covenants,” Barclays analysts wrote in a February 20 note.

Lily: Corporate debt frenzy bears a ‘strange’ resemblance to the subprime loan boom, says Zandi

Are the banks at risk?

Former Fed Chairman Janet Yellen and some investors say leveraged loans and CLOs are unlikely to provide the source of the next banking crisis, simply because banks are no longer the main investors nor the originators of leveraged loans and secured loan bonds.

Yet regulators fear their relationships with non-bank players will unfold in unpredictable ways.

“Banks are counterparties to these non-banks in all kinds of transactions,” said Mayra Rodriguez, senior director of MRV Associates, a consulting firm specializing in risk-based financial regulation and supervision matters, in a statement. interview with MarketWatch.

If the secured loan bond market crashes, banks may find it difficult to offload their loans in the absence of their biggest buyers. This could strain their balance sheets and potentially jeopardize lending in times of difficulty, according to Dallas Fed Chairman Robert Kaplan in an essay published Tuesday.

Banks also sometimes lend to CLO managers who use the funds to purchase leveraged loans which will then be bundled and turned into newly issued CLOs. A sudden drop in loan prices could result in heavy losses for banks lending to these “warehouses”, according to International Financing Review.

Mark Mason, C of Citigroup,
+ 1.12%
new chief financial officer and former head of the private bank, told analysts in January that the bank had about $ 5 billion exposure to CLO “warehouses”.

Forced sale

The potential scenario of thin and panicking mutual fund trading has also caused many to consider how a market downturn could create a vicious loop of falling prices and further selling.

“The relative illiquidity of leveraged loans and outflows from mutual funds leading to inflammatory sales could essentially cut the leveraged credit market from funding and, by this route, worsen the impact on the market. economy as a whole, ”wrote Marco Stoecke, head of credit research at Commerzbank, in a note dated February 7.

Investors had a little glimpse of how credit funds would handle large cash outflows after retail investors pulled out of mutual funds specializing in bank lending late last year. The series of exits and sharp price declines saw a benchmark basket for leveraged loans compiled by IHS Markit give up almost all of its gains for 2018 after earning a 4% return at the end of the month September.

Since January, leveraged loans have rebounded along with the rest of the corporate bond market.

What are regulators doing?

For the most part, regulators overseeing the banking sector, such as the Federal Reserve and the Financial Stability Board, have led the charge by monitoring the risks associated with leveraged loans.

Randal Quarles, Vice President of the Fed in charge of banking supervision and Chairman of the FSB, said in an interview with the Financial Times that the FSB would attempt to catalog CLO holders around the world in order to map the risks of strong exits by their investors.

But Rodriguez says that the regulatory focus on banks, the culprits of the latest financial crisis, has left the mounting problems in the non-banking sector unattended. The International Monetary Fund estimated that the assets of nonbank financial institutions relative to the annual economic output of the United States increased to around 160% in 2015, compared to 40% in the 1980s.

“It’s great that the Financial Stability Board and the Basel Committee on Banking Supervision focused so much on the banks, because they were at the epicenter of the crisis. But what about the regulation and supervision of non-banks? ” she said.

Because non-banks come in all shapes and sizes, including pension funds, private equity firms, family offices, hedge funds, and fixed income investment funds, there is no of single centralized regulator that has the ability to oversee their activities or power reviews on-site, Rodriguez said.

Also check out: Leverage loans are in uncharted territory and it’s a big risk, says Moody’s


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