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Leveraged Lending: From the Regulators’ Mouth(s)

December 6, 2018 - There have been a flurry of news stories recently on the regulators’ views on leveraged lending and systemic risk. Being curious (and determined) folk, instead of simply reading the news, we went to the original sources; we drilled into the actual speeches and the supporting documents to see exactly what the regulators said about credit risk (the risk of default and loss) and systemic risk (the risk that the financial system suffers a shock and freezes). Their views are rather more nuanced than the headlines.

We start with this week’s release of the OCC’s Semi-Annual Risk Assessment. The news was mixed. First, it notes that lagging asset quality metrics remain strong. C&I loans see delinquencies and non-accruals at about 1%, down nearly a full percentage point from early 2017. However, credit risk is building. The report observes that demand for higher yielding assets is permitting higher risk, lower quality and narrower pricing. Increased competition is begetting easing underwriting standards and risk layering. All of this could lead to lower recovery values than in previous downturns.

So, it may be fair to acknowledge that leverage is higher and documents are looser – and this may lead to future loan “recoveries given default” being somewhat below the historical 80% average. But does this create systemic risk? The perspectives of the regulatory heads are more nuanced than one might expect. The WSJ and LPC reported that Comptroller of the Currency Joseph Otting said while leveraged lending doesn’t currently present a systemic risk, banks should be wary of a contagious impact on companies to which they lend. Meanwhile, Fed Vice Chairman Randall Quarles said that the Fed has noted the growth of leveraged lending. But leveraged lending growth and evolving underwriting standards can occur “without necessarily posing either micro-prudential or macro-prudential risks”. Moreover, the role of CLOs as buyers may reduce the risk to banks and the system because CLOs have longer-term liabilities making them less “runnable.  But the Fed is looking at the space.

The most detailed thinking on systemic risk – and the role of the leveraged loan market – came from Fed Chairman Jerome Powell and the Federal Reserve’s Financial Stability Report. He discussed four vulnerabilities the Fed considers in the financial system.

First is excessive leverage in the financial sector. This created a downward spiral in the financial crisis when many entities had to deleverage simultaneously. (In the loan market, this happened with TRS and Market Value CLOs.) Chairman Powell noted that the Fed examines leverage across banks, hedge funds and funding vehicles such as securitizations and currently does not see abnormal leverage.

Second is funding risk, which occurs when financial entities rely on funding that can be rapidly withdrawn. In the financial crisis, there were runs on broker dealers, some part of the repo market and money market funds. Today, the Fed views funding risk as low (see Quarles’ comments on CLOs above). Thus, between a decline in leverage and funding risk, the Fed believes that financial institutions and markets are more resilient.

The third vulnerability is excessive debt loads. Chairman Powell points out that the ratio of corporate debt to GDP is about where one might expect after a decade of expansion. However, he warns that firms with high leverage and interest burdens have been increasing their debt loads the most, underwriting quality has deteriorated and leverage multiples have increased. In other words, credit risk has increased. However, he notes that the question for financial stability is whether bankruptcies would undermine the financial system’s ability to perform its critical functions on behalf of households and business. He answers that, “For now, my view is that such losses are unlikely to pose a threat to the safety and soundness of the institutions at the core of the system and, instead, are likely to fall on investors in vehicles like collateralized loan obligations with stable funding that present little threat of damaging fire sales.” But they are watching this space.

The fourth vulnerability is an asset bubble (a term he eschews in favor of “when asset values rise far above conventional historically observed valuation benchmarks”). Looking across asset classes, they see some whose valuations seem high relative to history. (Riskier forms of corporate debt are mentioned by Powell; however, as discussed by BloombergTV and the nearby secondary article, the loan market is looking a little softer.) Nonetheless, the Fed Chairman added, valuations generally are short of the pre-crisis boom.

Having reviewed the vulnerabilities, the Fed’s best guess is that overall financial stability vulnerabilities are at moderate levels. More broadly, as can be seen in all the recent speeches and publications, the regulatory agencies seem to be making the distinction between credit risk (which is accepted by consenting parties in a market) and systemic risk (which can have broader repercussions).

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