Is a leveraged credit crunch imminent? it depends who you ask

WASHINGTON – Concerns about the risks of leveraged loans are still moot, but vigorous debate over the threat posed by business credit is already in high gear.

Commentators, Democratic lawmakers and other observers are increasingly sounding the alarm that credit growth to highly leveraged companies could trigger the next crisis. But major financial institutions, GOP lawmakers, and even Trump-appointed regulators counter that the risk of leveraged loan losses triggering a 2008-like downturn is still low.

“We need to consider the possibility that” leveraged loans are a systemic problem, said Representative Gregory Meeks of New York, chair of the House Financial Services Subcommittee on Consumer Protection and Financial Institutions.

Both sides were fully exposed Tuesday during a hearing before the subcommittee, which heard from witnesses urging the financial services industry and policymakers to act now to avoid possible systemic shocks. Meeks noted that the matter appeared to demand the attention of the Financial Stability Supervisory Board, which discussed leveraged loans in a closed-door meeting last week.

“Due to their explosive growth and the rapid erosion of underwriting standards, leveraged loans have increased the vulnerability of the financial system. In the event of an economic downturn, this vulnerability has the potential to disrupt the availability of credit and reduce economic output, ”Gaurav Vasisht, senior vice president of the Volcker Alliance, said in testimony prepared for the subcommittee of protection of consumers and financial institutions. “To address this weakness, regulators should take the necessary steps to better understand and mitigate the risks of this complex market.”

But GOP members have held back, echoing concerns of many that the risks of leveraged loans are exaggerated. They note that the commercial banking sector is immune to a direct hit, as most of the risk of leveraged lending is in the non-banking sector and financial companies have been building up capital since the 2008 crisis. to be able to absorb the losses.

Senior sub-committee member Blaine Luetkemeyer, R-Mo. Said regulators should still monitor developments in leveraged lending, but systemic concerns are mitigated when one considers that banks hold less than 8% of leveraged loans.

“This evidence suggests little systemic risk to our financial markets,” Luetkemeyer said in his opening remarks at Tuesday’s hearing.

Greg Nini, a finance professor at Drexel University, agrees with the current consensus among regulators that leveraged loans do not pose systemic risks.

“The leveraged loan market does not appear to generate unique sources of systemic risk,” Nini said in prepared testimony. He added that secured loan bonds, the securitization instrument used to pool leveraged loans, “have stable funding sources and borrowers of leveraged loans have wide access to markets. capital “.

But Erik Gerding, a professor at the University of Colorado School of Law, warned that “the regulated financial sector is … exposed to the risk of leveraged loans” because CLOs have similar characteristics to complex investment vehicles. who suffered massive losses during the mortgage collapse. .

“CLOs are close cousins ​​of secured mortgage-linked debt obligations… which were at the heart of the global financial crisis 11 years ago,” he said.

Yet the banking industry also suggests that the risk is overstated.

Ahead of Tuesday’s hearing, Greg Baer, ​​chief executive of the Bank Policy Institute, wrote in a blog post that while leveraged loans have systemic implications, restricting the financial sector’s ability to provide credit. would be misguided.

“Almost daily, commentators are now voicing concerns about leveraged loans as a source of macroeconomic risk, and possibly a potential future crisis,” Baer wrote. “Leaving aside the question of whether this diagnosis is correct (and there are many reasons to believe that it is not), the proposed prescriptions seem extremely inappropriate for this diagnosis.”

Rather than restricting the loans banks can make or requiring more capital to be set aside, Baer said, policymakers should set limits on how much businesses can borrow.

“It’s a borrowing problem, not a lending problem, and the most direct and effective response would be to limit the leverage effect of American businesses, large and small, for example by prohibiting a business from investing. ‘borrow more than a multiple of its profits’. Baer said.

Representative Andy Barr, R-Ky., Said that unlike the cash races that followed asset losses during the 2008 crisis, CLOs are intended to be more stable.

“CLOs are long term capital,” he said. “They are not subject to short-term redemptions or outflows, and in that regard, CLOs are a vital source of liquidity in a downturn. This is exactly the type of structure that decision-makers should want. … Excessive regulation of CLOs would be an obstacle to financial stability.

But Bill Foster, D-Ill., Countered that instruments billed as fail-safe before the crisis turned out to be susceptible to huge losses.

“You probably see the difference between the members who were on this committee during the financial crisis and those who heard quite a different rewrite after the fact quite clearly,” Foster said. “Many, many previously safe financial products have become unsafe during this crisis. … Very few people had a clear idea.

Globally, new leveraged loan issuance hit a record $ 788 billion in 2017, surpassing the pre-crisis peak of $ 762 billion in 2007, according to a House Financial Services note. Committee. The United States had by far the largest leveraged loan market last year, accounting for $ 564 billion in new loans.

The regulators’ most recent report on shared national credit, which examines the state of the industry’s syndicated loan portfolio, said leveraged lending risk “is increasing relative to the portfolio as a whole.”

Federal bank regulators have flagged the risks associated with leveraged loans for years, but senior officials, to some extent, have downplayed the risks to commercial banks since most of the growth in assets has come about. produced in non-banks. Last year, the Comptroller of the Currency Joseph Otting notably said that banks “kind of stay on track” in leveraged lending.

Federal Reserve Board Chairman Jerome Powell last month said the financial system could withstand losses due to corporate debt problems.

“In the public debate on this issue, opinions seem to range from ‘This is a repeat of the subprime mortgage crisis’ to ‘Nothing to worry about here,'” said Powell. “Right now, the truth is probably somewhere in the middle.”

Yet agencies still point to increased risks. A December report from the Office of the Comptroller of the Currency on risks in the industry said that “the deterioration in the corporate bond and loan markets could affect supervised institutions more deeply than in previous periods.”

“In this environment of very high and high levels of leverage outside the banking industry, it is important for banks to look at a company’s suppliers or a company’s distribution network and understand the levels of leverage. leverage who are important partners in executing their business plan, ”Otting said upon the release of the risk report.

But Gerding criticized a decision by the OCC last year to stop enforcing bank regulators’ 2013 interagency guidelines on leveraged lending. The agency’s decision follows a Government Accountability Office finding that the guidelines were indeed void because they should have been published as official regulations under the Congressional Review Act.

“The supervisor’s decision degraded the ability of federal regulators to monitor the build-up of risk in the leveraged loan market – and, by extension, the CLO market that securitizes these loans – and banks’ exposure to leverage. that risk, ”Gerding said.

Janet E. Fishburn