March 6, 2019 - For months the financial press has been reporting on the Federal Reserve’s concerns with the leveraged loan market, but it wasn’t until Fed chairman Jerome Powell’s testimony before the House Financial Services Committee last Wednesday that he specified the actual extent of those concerns.
Asked whether the leveraged loan market poses “systemic vulnerabilities” to the economy, Powell said, “We don’t believe it poses systemic kinds of risks, but we do think it poses a macroeconomic risk, particularly in the event of an economic downturn.”
Powell added that the loan market does not present systemic risk in large part because banks are not exposed to its losses. “Our supervision of banks,” Powell said, “indicates that banks do not have excessively high exposures to these highly levered, non-financial corporations and also don’t have excessively large pipelines of commitments that they’ve made, which are two things they did have before the financial crisis but don’t have now.”
When asked if current regulation is robust enough to prevent a downturn in the leveraged loan market from contaminating other markets, Powell said he thought it was. “If there were unexpectedly high credit losses among non-financial corporates, then, yes, the banks should have plenty of capital and liquidity to absorb those losses… It would not be the kind of thing we saw in 2008.”
While concerns with the leveraged loan market have been voiced by other regulators, as well, they have been reluctant to specify the extent to which a downturn in the leveraged loan market might impact the broader economy. That was until Wednesday, when Powell was pressed on this issue specifically.
Powell’s clarifying remarks did not come as a surprise to those who have followed the debate closely. Most regulator remarks and reports have included caveat language tempering their concerns.
Most of these caveats focused, as Powell’s Wednesday remarks did, on the potential impact of a downturn in the loan market on banks and the financial system. The consensus is that the impact would be limited.
The Industry Responds
The focus by regulators on loan market risks has attracted the attention of in-house research departments at investment management firms and banks, some of which have now looked at the question in depth and issued reports.
The reports present a more explicitly nuanced view of the issue, clearly distinguishing between systemic risk and credit risk, and generally dismiss the notion that the loan market poses the former.
A report from Barclays, released February 22, notes that while they expect recoveries to fall by 5 to 10 points in the next default cycle, they think the systemic risks associated with an increase in covenant-lite loans are “likely overstated.”
The report points out elsewhere that the increased demand for cov-lite loans tracks a corresponding decreased demand for high-yield bonds. Because cov-lite loans still offer greater protections than high-yield bonds, the net overall protection for credit investors has actually increased, not decreased.
PIMCO issued a report on the loan market in February. It contains an implicit response to those who compare the current CLO market with the CDO market of 2008.
PIMCO notes the transparency of the issuers of loans underlying CLOs. “These corporations provide lenders with quarterly audited financials, provide regular updates to investors, and provide a good deal of visibility into their financial health.”
The current CLO market therefore stands in “stark contrast to the mortgage asset-backed securities market pre-crisis… The no-doc, interest only, and subprime loans to individuals buying homes bear little resemblance to even the lowest quality syndicated bank loan to a corporate issuer.”