26 November 2018

The $1.3 trillion loan market that’s spooking everyone right now

By Eshe Nelson

The International Monetary Fund has decided its time to sound the alarm about leveraged loans. It’s a $1.3 trillion global market comprised of debt built up by companies in precarious financial positions.

The IMF expects global issuance of these loans to companies that are either heavily indebted already or have weak credit ratings to be around $750 billion this year, after a record $788 billion in 2017. Ten years after the global financial crisis, investors are once again showing increasingly risky behavior as they search for sources of high yield in response to a decade of low interest rates (enacted by central banks in response to the crisis).

The largest market for leveraged loans is the US, where industries including technology, energy, telecommunications, and healthcare are using the debt to fund mergers and acquisitions, buyouts, dividends, or share buybacks. “In other words, for financial risk-taking rather than plain-vanilla productive investment,” the IMF said.

The IMF added that “the most highly indebted speculative grade firms” make up more of the new issuance of leveraged loans than they did before the financial crisis. Meanwhile, there are fewer investor protections—known as covenants—in new loans. These “covenant-lite” loans make up 80% of new loans arranged for nonbank lenders, up from about 30% in 2007. To make matters even worse, the quality of covenants has deteriorated, the IMF added.

This week, US senator Elizabeth Warren sent a letter to regulators laying out concerns about falling underwriting standards for leveraged loans, warning that they create a significant risk to the US economy. “I am concerned that the large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market,” she wrote.

Janet Yellen, the former chair of the US Federal Reserve, has also recently added her voice to the warnings. Yellen said there had been a “huge deterioration” in lending standards and was worried about systemic risks associated with these loans. It’s particularly troubling because it’s happening at a time when bank regulation is being relaxed. She said these loans could bankrupt firms in an economic downturn, making it worse.

“You are supposed to realize from the crisis, it is not just a question of what banks do that imperils themselves, it is what they do that can create risks to the entire financial system,” Yellen said last month in an interview with the Financial Times (paywall). ”That lesson to me seems to have been lost.”

Also last month, the Bank of England said it was also concernedabout the increase in leveraged lending, saying that global market is larger than–and growing as quickly as–the US subprime mortgage market was in 2006. Issuance in the UK hit a record last year. The Bank of International Settlements, meanwhile, warned that characteristics of this market make it vulnerable to additional risks, such as its relative illiquidity.

The growth in the leveraged loan market is part of a boom in collateralized loan obligations (CLOs). This is a form of securitization in which leveraged loans are pooled together and then divided into tranches. They are something like a cousin to collateralized debt obligations (CDOs), the assets that blew up spectacularly during the global financial crisis. CLOs are deemed safer because they made it through that crisis relatively unscathed.

But like with the debt that underlies them, the standards attached to CLOs are weakening. Bloomberg recently warned that the market has gone too far now these risky assets are targeted at individual retail investors. What’s more, there are concerns that existing regulations don’t sufficiently protect against the risks of leverage loans and CLOs, which are often being built up by nonbank lenders.

“Having learned a painful lesson a decade ago about unforeseen threats to the financial system, policymakers should not overlook another potential threat,” the IMF said.

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