Financial watchdog warns of leveraged loan dangers

A limited number of big banks have the most exposure to these markets, Financial Stability Board says

The boom in the market for leveraged loans, a favourite financing source of private equity-backed companies, has created vulnerabilities in the global financial system, according to a report from international regulators.

A limited number of big banks are most exposed to these markets because they arrange the loans and hold some of them while also offering borrowers revolving credit facilities, according to the Financial Stability Board, a collection of global central-bank officials.

The same banks also arrange and underwrite the creation of structured investment funds known as collateralised loan obligations.

The market for leveraged loans has grown rapidly in recent years, supported by the creation of CLOs, and may range in size from $1.4tn to $3.2tn globally, depending on the types of lending included.

CLOs have boomed again as investors hungry for yield have returned to a kind of investment that was last popular in the run-up to the 2008 credit crisis.

Banks globally had almost $1.4tn of loans and revolving credit facilities to these riskier borrowers at the end of 2018, much of which hadn’t been drawn down, according to the FSB. On top of that, banks had almost $340bn of exposure to loans and CLOs at the end of 2018, some of which are meant to be held only temporarily.

The FSB identified the holders of 79% of leveraged loans and 86% of CLOs, but said little was known about the exposure of certain nonbank investors to these markets.

“Given data gaps, a comprehensive assessment of the system-wide implications of the exposures of financial institutions to leveraged loans and CLOs is challenging,” the FSB said.

The US dominates leveraged-loan markets, but the FSB, which is chaired by Federal Reserve vice chairman Randal K. Quarles, produced the special report to draw together different sources of information globally — both to identify risks and to find the gaps in knowledge about the market.

“This report provides a fact base that authorities and market participants can use to help assess the risks posed by leveraged loan and CLO markets and respond accordingly,” Quarles said.

The Federal Reserve warned last month that the leveraged loan market is growing quickly despite consistently weak credit standards, joining other regulators in flagging the risks.

The Bank of England also wrote about the risks associated with leveraged loans in its financial stability report this week, pointing to high leverage that was often understated by borrowers and weak documentation. In January, it published a study comparing the loan market to pre-2008 sub-prime mortgages in the US.

Vulnerabilities have grown in the markets because companies are borrowing more relative to their earnings, or using greater leverage, the FSB said. At the same time, the terms in loan documentation have weakened, according to the report, while the changing makeup of investors involved might have increased market complexity.

Higher leverage makes companies riskier because more of their earnings will have to be used to repay debt, which becomes even more difficult in a slowing economy.

Source: Financial News

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