Leveraged-Loan Risk Guidance From 2001 May Be Updated by U.S. Regulators

Regulators are considering new guidelines on risks and lending standards for banks that originate and sell high-yield, high-risk loans to account for the experience of the financial crisis.

The guidance by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. is geared toward the largest financial institutions that underwrite leveraged loans, which can exceed $1 billion, said Andrew Gray, a spokesman for the FDIC.

“The FDIC is working with other federal regulatory agencies on considering whether to update the April 2001 guidance on leveraged financial activities to clarify regulatory expectations given lessons learned from the recent financial crisis,” Gray said in a telephone interview in Washington.

Regulators are taking a harder look at financial-market and bank-lending trends with an eye toward spotting excessive risks that could destabilize the financial system. To that end, the OCC has boosted the analytical data and tools used by its National Risk Committee, and the Federal Reserve has established an Office of Financial Stability Policy and Research.

“This is a sector where there can be a terrific amount of risk because of the embedded leverage and because of other business the bank may be doing with the borrower,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington firm that researches regulation for the nation’s biggest banks. “Guidance puts the bank’s risk management office on notice that they should have been in there looking at leveraged loans, and it insures there are standards set industry wide.”

Acceptable Standards

While guidance isn’t enforceable, it outlines acceptable standards and risks and provides examiners with a rationale for targeting leveraged loans for heightened surveillance in their day-to-day bank oversight.

The OCC published a handbook on leveraged lending in February 2008, which explained the market and outlined risks such as “airballs,” or deals that are under-collateralized. Regulators are also considering so-called “pipeline risk,” which occurs when a bank has difficulty selling off the loan, in their current review, according to a person familiar with the discussions, who declined to be identified because the talks are private.

High-yield, high-risk loans are used for everything from mergers and acquisitions and buyouts to recapitalizations. The debt is ranked below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.

Leveraged loans typically have more protections for creditors than high-yield bonds, and loan investors get paid out first in the event of a default. Companies such as Kinetic Concepts Inc. (KCI), Asurion Corp. and Energy Transfer Equity LP have issued leveraged loans in the past six months.

Volumes Jump

Volumes jumped to $373.1 billion last year, a 59 percent increase from 2010 and the most since record sales of $535.2 billion in 2007, according to S&P Leveraged Commentary and Data. Buyers of the loans include other banks, structured credit funds, hedge funds and state pension funds.

The S&P/LSTA Leveraged Loan 100 Index (SPBDLLB), which tracks the 100 largest dollar-denominated first-lien loans, rose 0.03 cent to 93.2 cents on the dollar on Feb. 27. It’s up from a record low of 59.2 cents on Dec. 17, 2008, three months after the collapse of Lehman Brothers Holdings Inc.

The Federal Reserve’s low-rate policy has helped drive more cash into high-yield assets. The U.S. central bank has held the benchmark lending rate between zero and 0.25 percent since December 2008 and is pushing down long-term rates by extending the duration of its $2.6-trillion securities portfolio.

Pension Funds

State pension funds and retirement plans have been unable to meet annual return benchmarks because of the extended period of low interest rates, said Martin Fridson, global credit strategist at BNP Paribas Investment Partners. That has helped increase demand for high-yield debt.

“I don’t think there is any question there is pressure to raise returns on these portfolios because of the difficulties of increasing contributions when state money is not plentiful,” said Fridson, who is based in New York. “Something has to give, and part of what’s giving is that pension plans and retirement systems are looking for ways to raise the yields on their portfolios.”

The Federal Open Market Committee in January said the benchmark lending rate would remain “exceptionally low” through at least late 2014, extending an earlier date of mid- 2013.

The U.S. 10-year note dropped two basis points, or 0.02 percentage point, to 1.91 percent at 1:43 p.m. New York time. The yield dropped to a record 1.67 percent on Sept. 23.

Regulatory Scrutiny

The leveraged-loan market has been falling under regulatory scrutiny on and off for more than a decade.

Regulators last issued joint guidance in 2001, when mergers and acquisitions helped lift leveraged financings to one-third of syndicated bank loans, according to their letter at that time. Regulators warned of “undue concentrations,” and the use of “unrealistic assumptions to determine enterprise value.”

Fed Vice Chairman Janet Yellen in June pointed to risks in the leveraged-loan market in a speech on potential financial imbalances. She highlighted narrowing spreads and “deals that do not provide investors with the traditional protection of maintenance covenants.”

About $47.9 billion in dollar-denominated leveraged loans were arranged last year without financial maintenance covenants, up from $7.64 billion in 2010, according to data compiled by Bloomberg. Maintenance covenants are provisions in a credit agreement that require the company to hit certain financial targets, such as interest-coverage ratios.

Del Monte Foods

San Francisco-based Del Monte Foods Co. (DLM), the maker of pet foods Meow Mix and Milk Bone, got a $2.5 billion so-called covenant-lite term loan in January 2011, the largest single tranche loan that year that didn’t contain financial maintenance provisions, Bloomberg data show.

The financing was to support its leveraged buyout by KKR & Co., Vestar Capital Partners and Centerview Partners LLP.

Yellen, in her June remarks in Tokyo, said the Fed would “continue to watch conditions in the leveraged-loan market closely in the coming months, and we will speak out forcefully if we perceive pressures continuing to build.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Cheyenne Hopkins in Washington at +1- chopkins19@bloomberg.net; Richard Bravo in New York at rbravo5@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net; Faris Khan at fkhan33@bloomberg.net

Press spacebar to pause and continue. Press esc to stop.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.