One of the Federal Reserve’s first post-crisis tests of its ability to quash excessive risk-taking using regulatory tools is so far looking like a failure.
The Fed’s Board of Governors told Congress last week that it’s engaged in “strong supervisory follow-up” to guidance given to banks in 2013 to improve their underwriting standards for high-yield loans. Despite those efforts, Chair Janet Yellen said she’s still seeing a “marked deterioration” in quality.
For the first time, more than half of the junk-rated loans arranged in the U.S. this year lack typical lender protections like limits on the amount of debt borrowers can amass relative to earnings. Yellen’s own easy-money policies are boosting demand for such high-yielding products at the same time that she tests her doctrine that financial bubbles should be constrained by supervisory actions, not a general rise in interest rates.
“Regulators talk about using tools and other supervisory measures to rein in the banks,” said Beth MacLean, an executive vice president and bank-loan money manager at Pacific Investment Management Co. in Newport Beach, California.
“But ultimately there is still supply and demand, and there is ample demand,” MacLean said. “There is not much they can do, and that is evident in that terms haven’t really changed since the guidelines came out.”
The Fed’s semi-annual report to Congress last week said that the share of leveraged loans “rated B or below has moved up further,” and said the central bank is responding with “supervisory reviews” this year and letters to banks requiring action.
Regulators are also conducting their annual review of bank loans, called the Shared National Credits Review. A final report will be released in the next few months, which may give supervisors justification to escalate their scrutiny of a market that’s booming amid a sixth year of near-zero interest rates.
“Zero is encouraging people to take risk and credit spreads to narrow to unprecedented levels,” said Brad Hintz, a banking analyst at Sanford C. Bernstein & Co. “Almost anything you invest in or buy looks pretty good when you finance it at zero.”
Issuance of new leveraged loans this year totals $226.7 billion, on pace to surpass the record $358.3 billion of new loans in 2013, according to data compiled by Bloomberg. The debt is often used to fund takeovers, such as the more than $2 billion of loans arranged last month to finance Blackstone Group LP’s buyout of industrial-products maker Gates Global LLC.
The market for loans rated below investment grade may be setting itself up for greater losses than in past cycles because companies will struggle to refinance debt cheaply as interest rates rise from record lows, Martin Pfinsgraff, the top large-bank supervisor at the Office of the Comptroller of the Currency, said this month in an e-mailed response to questions from Bloomberg News.
“We are concerned with compliance and reputation risks among the institutions we supervise as well as the significant litigation risk banks may face if they fail to effectively originate or underwrite products they sell,” Pfinsgraff said.
If regulators see banks ignoring their guidance, one possible next step would be to “serve up a head on a pike,” by taking action against a specific bank as a warning to the industry, said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc., a Washington-based firm that analyzes regulation for the world’s largest banks.
Yellen, in her congressional testimony last week, said protecting the U.S. economy from systemic financial risk is an “unwritten third mandate for the Federal Reserve,” along with low unemployment and price stability. The Fed chair said earlier this month in a speech at the International Monetary Fund that supervisory tools should play a “primary role” in attacking bubbles as raising borrowing costs “faces significant limitations.”
Her views place her in a group of Fed officials JPMorgan Chase & Co. chief U.S. economist Michael Feroli calls “the separatists,” who want to address financial-stability concerns mainly with regulation. At the other end of Feroli’s spectrum are officials such as Kansas City Fed President Esther George, who is concerned that the long period of low interest rates is leading to financial imbalances.
Regulators have so far had limited ability to get banks to turn down risky deals, according to Brian Kleinhanzl, an analyst at Keefe, Bruyette & Woods in New York.
The Fed, OCC and Federal Deposit Insurance Corp. in March 2013 updated leveraged-lending guidance, saying debt levels of more than six times a measure of profitability “raises concerns.” Underwriting should also consider a borrower’s ability to pay down debt to a sustainable level within a “reasonable period,” they said.
“The banks are lending freely, quite freely,” Kleinhanzl said. “The guidance had many loopholes” and regulators “need to give more specific criteria and say these are the ratios that must be used by industry.”
Covenant-light loans, those credits that lack typical lender protections, total $164.9 billion this year compared to $314.8 billion in all of 2013, according to data compiled by Bloomberg. Defaults by borrowers of these high-risk credits are more frequent than on all of their junk-rated peers, according to Moody’s Investors Service.
The leveraged-lending guidelines “have been implemented to varying degrees across the Street, to put it kindly,” Citigroup Inc. analysts led by Michael Anderson wrote in a July 18 report.
The market may be “at risk of more forceful regulatory action than what was experienced last year,” he wrote.
Leverage in second-quarter buyouts rose to 5.9 times, a post-crisis high, Anderson wrote, citing data from Standard & Poor’s Capital IQ Leveraged Commentary and Data.
“Looking at everything in 2014, we haven’t seen much tightening” of credit agreements, said Jessica Reiss, an analyst at Moody’s in New York who focuses on covenants and credit agreements. “It’s more of the same.”
The Fed will probably keep its benchmark lending rate between zero and 0.25 percent until 2015, according to policy makers’ projections. The central bank has held the rate there since December 2008.
“The Fed has pursued a super-easy policy path with the intent of reviving employment,” said Lawrence Goodman, president of the Center for Financial Stability Inc. in New York.
“Supervisory tools are essential,” yet “history is littered with examples” of how they didn’t slow bubbles, excessive leverage and bad investment, he said.