U.S. Regulators to Overhaul Supervision of Leveraged Loans

The three top U.S. banking regulators will issue tougher guidelines for high-risk, high- yield loans, asking today for public comment on the proposed rules.

“While there was a pull-back in leveraged lending during the crisis, volumes have since increased, while prudent underwriting practices have deteriorated,” the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency said in a release in Washington.

Regulatory agencies have boosted their surveillance of financial-market and bank-lending trends to avert the emergence of asset bubbles that may lead to financial turmoil. While guidance isn’t enforceable, it details acceptable standards and provides examiners in routine bank exams with a rationale for targeting leveraged loans for tougher oversight.

Debt agreements “have frequently included features that provide relatively limited lender protection, including the absence of meaningful maintenance covenants,” the agencies said.

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

‘More Specific’

“They’ve decided they need to be much more specific about what banks need to do when they get into this kind of lending because of the riskiness regulators see,” said Brad Sabel, a partner at Shearman & Sterling LLP in New York.

“The real guts of this is the granular stuff on reporting and internal controls and appraisals and what they expect to see if you get significantly involved in this business,” said Sabel, a former attorney for the New York Fed.

The KBW Bank Index -- which tracks shares of 24 U.S. companies, including Bank of America Corp. and Capital One Financial Corp. -- rose 1.2 percent to 50.11 at 2:48 p.m. in New York.

“Many institutions have found themselves holding large pipelines of higher-risk commitments at a time when buyer demand for risky assets diminished significantly,” the agencies said.

High-yield, high-risk loans, or “leveraged 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.

Pension Funds

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’s Capital IQ Leveraged Commentary and Data. Buyers of the loans include other banks, structured credit funds, hedge funds and state pension funds.

The agencies said they want to focus examiners and banks on five areas, including better oversight by boards. They want banks to improve information systems and better control the risks of loan distribution and the circumstances of a disrupted market.

The regulators plan to require improved risk management of leveraged loans, including requiring management to identify an institution’s risk appetite for leveraged financing and quarterly reporting by senior management to the board of directors.

Today’s release updates guidance from April 2001, in which regulators warned of “undue concentrations” and the use of “unrealistic assumptions to determine enterprise value.”

Manage Risk

The 2001 guidance highlighted the need for “comprehensive credit analysis processes, frequent monitoring and detailed portfolio reports to better understand and manage the inherent risk in these leveraged finance portfolios.”

In February 2008, the OCC also issued a comptroller’s handbook on leveraged lending, which explained the market and outlined risks such as “airballs,” or deals that are under- collateralized.

Regulators have seen “tremendous growth” in the volume of leveraged credit, participation of non-regulated investors, limited lender protection in debt agreements and “aggressive” capital structures and repayment prospects, their statement said today.

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

‘Watch Conditions’

The Fed will “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,” she said.

The Fed’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.

The regulators said the “vast majority” of community banks shouldn’t be affected because they have little exposure to leveraged loans. Comments on the proposal must be submitted by June 8.

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

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

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