October 19, 2017 - In a step that could have far reaching implications for the loan market, on Thursday, the Government Accountability Office (“GAO”) issued an opinion that Leveraged Lending Guidance (“LLG”) issued jointly by the OCC, the Federal Reserve Board and the FDIC (the “Agencies”) is a “general statement of policy” and therefore considered a “rule” for purposes of the Congressional Review Act (“CRA”) and must be submitted to Congress for review. For the uninitiated, this could be big. Really big. The GAO’s decision is available here.

As we reported on April 6th, the GAO’s report was in response to a letter submitted by Senator Pat Toomey (R, PA) asking whether the LLG, styled as “guidance” by the Agencies, was actually a rule under the CRA.  What are the implications of the GAO ruling? It could, theoretically, mean that LLG is changed – or even goes away.  Here’s the nitty-gritty. The CRA permits Congress to reject rules finalized within the prior 60 legislative days (as was done with numerous regulations earlier this year). Under the GAO’s ruling, even though the LLG was issued in 2013, the banking agencies must now submit the LLG to Congress for review. This would start the 60-day clock and allow Congress to disapprove the Guidance through a resolution approved by simple majorities of each of the House and Senate (with no ability to filibuster). Importantly, if Congress disapproves a rule, it is effectively null and void and, significantly, cannot be re-proposed in a similar form.  For a deep dive into the GAO process and how the CRA works and could impact the LLG, please click here to read our memo from May 23rd (prepared by Sidley Austin).

Still, why does this matter?  The LLG has had a significant effect on the leveraged loan market in two major ways.  First, the LLG has effectively prevents banks from “originating” any loans that would be “non-pass” credits under the Shared National Credit (“SNC”) Review.  Non-pass is generally defined as loans where the borrower cannot demonstrate the ability to repay from free cash flow 100% of its secured debt or 50% of its total debt within 5 to 7 years.  Importantly, “origination” of loans is very broadly defined to include not only the underwriting and distribution of new loans, but the refinancing or modification of existing loans.  The LLG has also had a major impact on non-leveraged loans that are nonetheless swept up in the leveraged categorization. To illustrate, in the most recent SNC Review, which assesses credit risk trends in the syndicated loan market, the big news was the near-doubling of the leveraged loan portfolio.   Exhibit 4 on p. 6  shows that the size of SNC Leveraged Lending Commitments soared by $792 billion (or 82%!) to $1.76 billion. The following paragraph explained that near-doubling of the leveraged loan portfolio was primarily due to banks “recalibrating leveraged loan definitions to meet regulatory expectations of committed senior debt above three times EBITDA or committed total debt above four times EBITDA, except in industries or sectors where banks have documented appropriate reasons for other leverage levels”.

In other words, banks’ definition of “leveraged” changed. This is rather important. The LLG has forced banks to classify many investment grade or near-investment grade companies (with senior leverage over 3x or total leverage over 4x) as leveraged companies for the purposes of the guidance. Why does this matter? To begin, it involves considerable costs for banks. There were significant initial MIS outlays to capture investment grade “leveraged” deals, and the ongoing reporting costs are non-trivial. But more serious may be the impact on banking decisions. First, including a significant number of investment grade loans in a “leveraged” portfolio can skew banks’ risk analyses. In addition, banks set risk limits based on their portfolio size. We have heard that the addition of “non-leveraged” loans has filled some banks’ leveraged loan limits, perhaps reducing their ability to make actual leveraged loans.

So, what happens now?  The GAO will meet with the Senate Parliamentarian and decide whether, as the GAO concludes, the LLG is a rule subject to CRA and, if it is, require the Agencies to submit the LLG to Congress.  Once they do that, it would start the clock.  Congress will then have 60 legislative days to decide whether to pass a joint resolution disapproving the LLG and that resolution would have to be signed by the president.  It is way too early to predict how the politics will play out, and how the Agencies will react but we will continue to closely monitor the situation.  We will have more to say on the GAO opinion and its possible impact on LLG next week.

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