January 24, 2019 - Reports continue to appear about regulators opining on the leveraged loan market. And so, we once again go to the original sources to see what they are saying. We began this process in December, when we recapped views from the OCC Semi-Annual Risk Assessment and the Federal Reserve’s Financial Stability Report, as well as speeches and comments from Fed Chairman Powell, Vice-Chairman Quarles and Comptroller Otting.
Since early December, several reports have highlighted a Janet Yellen speech where she discussed leveraged lending. We went searching and determined that, yes, Dr. Yellen definitely did address leveraged loans in a wide-ranging hour-plus interview at CUNY in December. While she definitely has questions about leveraged lending, her views may be more nuanced than were widely reported. First, when discussing 2008 and what worries her now, Dr. Yellen said “I don’t see a shock in the offing that is likely to cause that kind of financial crisis.” She went on to say, “I worry about leveraged lending…that high levels of corporate leverage could prolong the downturn.” That part was widely reported. What was not widely reported is what she went on to say, and we quote in full, “But there’s much less leverage in the financial sector now as far as I can see relative to before the crisis. I think most of these risky loans are owned by investors that are not leveraged. So they may suffer some losses, but they are unlikely to turn around and start selling other assets that can lead to a firesale contagion.” It seems to us that Dr. Yellen is distinguishing between credit risk and systemic risk.
Next up, IMF. Some reports also suggest that the IMF recently raised warning flags about leveraged lending. To get the full scoop, we reviewed the IMF’s Stability report, which asked, “A Decade After the Financial Crisis: Are We Safer?” Indeed, the report did mention leveraged loans – four times in 81 pages (on pps. 7, 8 and 11 if you’re looking). Page 7 addressed the issue most directly, observing that “the share of highly levered and speculative-grade firms in new debt issuance has grown, fueled by strong investor demand, looser underwriting standards, and compressed spreads. Notably, highly leveraged deals account for a growing share of new leveraged loan issuance and have surpassed precrisis highs.”
Expanding our search beyond leveraged lending, we found that the report noted that near-term risks to financial stability have increased modestly, while medium term risks remain elevated because of persistent financial vulnerabilities linked to high debt levels and stretched asset valuations. When we searched out “stretched asset valuations” (p. 11), first on the list was stretched U.S. equity valuations. But the fourth risk flagged was that high yield bond and loan spreads have tightened materially, and ‘[loan] markets may be underpricing the deterioration in covenant quality, which is at the weakest level on record.”
So, if it’s an issue, what is a regulator to do around corporate debt? On p. 30 the IMF suggested that regulators should continue to monitor bank lending to highly indebted private non-financial and sovereign borrowers. More specifically, on p. 31, they suggest regulators watch the excessive buildup of leverage in the corporate sector.
And, to be fair, that is basically what we found referencing leveraged lending in the IMF Stability report. The reality is that a much larger portion of the report focused on risks building up in emerging and frontier markets, as well as sovereigns. We recommend that discerning parties read the full 81-page report, along with the headlines it may have generated.