March 3, 2021 - For years, commentators have debated whether leveraged loans have credit risk (the risk of losing money due to principal loss), systemic risk (the risk that defaulting leveraged loans could impair the financial system) and/or macroeconomic risk (the risk that leveraged companies could amplify a downturn due to defaults and bankruptcies). While these questions haven’t been fully answered, the Covid-19 crisis certainly stands as an ongoing stress test. What’s new this week is that the Shared National Credit (“SNC”) Review also may be considering these issues.

First, the background: SNC tracks loans of $100 million or more that are “shared” by at least three regulated banks. Thus, it can be analogized to the (bank originated) syndicated or clubbed loan market.  In 2020, SNC tracked $5.3 trillion in commitments and outstanding loans, up from $4.8 trillion in 2019. But volumes weren’t the story of 2020; credit quality was. To be sure, credit quality deteriorated: the share of “criticized” assets – those risk rated “special mention”, “substandard”, “doubtful” or “loss” – nearly doubled from 6.9% to 12.4% of the SNC portfolio. The volume of criticized loans approached $630 billion, nearly the level ($642 billion) hit in the financial crisis. However, at 12.4%, the share of criticized is far below financial crisis levels (22.3%), below 2002 (12.6%) and 2003 (12.5%) levels – and not that far from 2016 levels (10.2%).  Thus, despite a very severe macroeconomic impact, to date Covid-19 has not created the level of loan impairments of earlier periods.

Unsurprisingly, the increase in criticized loans in 2020 came “largely because of borrowers in industries heavily affected by COVID-19, such as entertainment and recreation, oil and gas, real estate, retail, and transportation services.” Moreover, as the COW demonstrates, leveraged companies in these “Covid-impacted” industries were more likely to fall into criticized territory in 2020. The share of criticized leveraged covid-impacted companies jumped from 13.5% in 2019 to 29.2% in 2020. In contrast, the share of criticized non-leveraged Covid-impacted companies climbed from 4.2% to 11.7%. This did not go unnoticed by SNC, which commented that “[b]orrowers with elevated leverage are especially vulnerable as they often have reduced financial flexibility to absorb or respond to external challenges such as the COVID-19 pandemic.”

But leverage levels are not the only issue. Much ink has been spilled in recent years about the loosening of loan documentation and how that might impact loan performance in a downturn. SNC linked documents to performance. The Review noted that more loans developed “layered” risks – including high leverage, aggressive repayment assumptions, weakened covenants, or permissive borrowing terms – and these characteristics along with an exogenous shock contributed to the rise in criticized assets.

The bottom line may be what we know: There is credit risk in leveraged loans (in fact, that is the risk for which investors are paid), looser documents may worsen outcomes, and leveraged companies are less well positioned to absorb exogenous shocks.

But does this suggest that these risks could endanger banks or, more broadly, the financial system? Perhaps not. SNC addressed bank management in Covid-19, noting that “credit risk management practices, including risk limit frameworks, adopted during the economic expansion are being tested during the current economic downturn.” But banks are taking action, and SNC added that “[m]any agent banks have strengthened their risk management systems since the prior downturn and are better equipped to measure and monitor risks associated with leveraged loans in the current environment.” (We would note that another governmental agency, the GAO, did not yet find systemic risk in leveraged lending or CLOs.

A reasonable question is whether the 2020 SNC Review is too early and whether the 2021 Report will show worsening outcomes. We are cautiously hopeful that this will not be the case. For one, credit metrics are beginning to look a little bit better. LCD reports that the trailing 12-month default rate in the S&P/LSTA Loan Index dropped to 3.25% in February. This marks the fifth straight month of declines and brings the default rate to within striking distance of its long-term average. And the prognosis may be for continued improvement. First, Fitch noted that its “Loans of Concern” volume has dropped for 10 consecutive months and is at the lowest level since July 2019. Second, S&P’s downgrade-upgrade ratio has improved significantly. After topping out at more than 43 downgrades for every upgrade last May, the ratio has been sitting around 1:1 for the last few months. In February, it dipped below 1, meaning that there were more upgrades than downgrades.

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