Attack on Junk-Loans Risks LBO Profits as U.S. Cracks Down
Fees for bankers and payouts for leveraged-buyout funds are at risk of being crimped as federal regulators crack down on underwriting standards in the market for high-risk, high-yield loans.
The government, in an annual review of bank credit, looked at a $429 billion sample of leveraged loans and found 42 percent were “criticized,” or classified as having a deficiency that might lead to a loss. Starting in September, it sent letters demanding banks draw up plans to improve the quality of their loans and a warning that regulators will pay close attention to high-risk loan performance in stress tests.
“We’re looking to deter the origination of criticized or below-standard loans,” Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the Office of the Comptroller of the Currency, said in an interview last week. Regulators are “trying to say to the industry, ‘Look, there are certain standards that if you dive below, we will criticize.’”
The attempt to curb froth in the leveraged-loan market will test whether regulators have the tools to stop asset-price bubbles from emerging more than five years after the financial crisis triggered the worst recession since the Great Depression. Federal Reserve efforts to spur growth with near-zero interest rates and asset purchases are causing investors to rush into higher-yielding debt, undeterred by declining credit quality.
“You got a higher growth rate in high-risk assets basically because we have a rate environment that enables that,” Pfinsgraff said.
The crackdown threatens to hamper a boom in fees for Wall Street. Debt-underwriting revenue at eight of the largest U.S. and European investment banks, including JPMorgan Chase & Co. (JPM) and Deutsche Bank AG, rose 19 percent in the first nine months of this year to about $14.3 billion, the most since the credit crisis, according to data compiled by Bloomberg. Much of the increase this year has been driven by leveraged finance, industry analytics firm Coalition Ltd. said in an August report.
“It would hurt the banks if you put a crimp in their business,” said Martin Fridson, chief executive officer of FridsonVision LLC, a New York research firm specializing in high-yield debt. “Leverage is getting up there,” which is a “warning sign.”
Tighter credit could also curb profits for private-equity firms, if they are forced to put up more cash for their takeovers or are restricted from piling additional debt onto their portfolio companies for purposes such as paying themselves dividends. The amount of leveraged buyouts announced this year has climbed to $118.1 billion from $91.4 billion in the same period last year, according to data compiled by Bloomberg.
U.S. banking regulators, including the Fed, OCC and Federal Deposit Insurance Corp., have been taking a targeted approach to the market, beginning with an advisory in March that outlined specific underwriting criteria such as leverage ratios and a timeline for debt repayment.
That was followed starting in September by individual letters to banks, including JPMorgan and Barclays Plc, after the agencies learned in their annual loan survey that their advisory wasn’t being heeded. Regulators told the banks they had 30 days to come up with a plan for tighter policies, according to four people familiar with the notices.
The Fed warned this month that it would pay close attention to high-risk loan performance in stress tests designed to gauge banks’ ability to withstand economic shocks. The stress tests would seek to build resiliency against losses by demonstrating that high-risk loans may need bigger capital buffers, while also showing banks they need to tighten lending standards.
Tasha Pelio, a JPMorgan spokeswoman, and Brandon Ashcraft, a Barclays spokesman, declined to comment. Andrea Priest, a spokeswoman for the Federal Reserve Bank of New York, also declined to comment.
Leveraged loans, also called high-yield or junk-rated loans, are made to companies rated below Baa3 by Moody’s Investors Service or lower than BBB- by Standard & Poor’s. New loans originated this year to speculative-grade companies have reached $259.8 billion, a 23 percent increase over the same period last year, according to data compiled by Bloomberg.
Of the debt issued this year, a record $64.9 billion was borrowed to pay dividends, according to Bloomberg and S&P Capital IQ Leveraged Commentary & Data as of Nov. 5. ARG IH Corp., which operates 3,428 Arby’s Restaurants, has asked for $370 million of loans to pay a dividend of that amount to its private-equity owner Roark Capital Group, according to Moody’s, which called ARG’s financial policies “aggressive” in an Oct. 31 report.
Regulators are aiming to eliminate some of the froth so they can mitigate the damage when credit tightens, Pfinsgraff said. Companies are using low borrowing costs as an opportunity to amass more debt and stretch their ability to pay it down, he said.
“There’s more of a willingness to now think about using supervisory policy as a targeted tool to deal with macro policy concerns,” said Robert Eisenbeis, chief monetary economist at Cumberland Advisors in Sarasota, Florida, and a former research director at the Fed Bank of Atlanta. “Whether that will work or not is an open question.”
Lending standards have slipped even after the Fed, the OCC and the FDIC issued underwriting guidelines in March. About $168.8 billion in so-called covenant-light loans were issued from April 1 to yesterday, compared with $100.8 billion for all of 2012, according to data compiled by Bloomberg. Covenant-light loans lack standard protections for lenders such as limits on the amount of debt a company can have relative to its cash flow.
Regulators are being more prescriptive in their guidance than they were in 2006, when warning about subprime home loans. Supervisors then sought to ensure loan terms included a “consideration of a borrower’s repayment capacity.” Now, their leveraged-loan guidance says a leverage ratio of more than six times earnings before interest, taxes, depreciation and amortization, or EBITDA, “raises concerns.”
Pfinsgraff said regulators have a “whole array” of tools available if banks ignore their directives. These include cease-and-desist orders and lowering the supervisory scores that regulators give to banks. A lower rating can affect a bank’s flexibility to buy back stock, pay dividends, engage in mergers and expand branches. Pfinsgraff said it’s “too early to tell” if banks are changing their lending practices.
Regulators may have more success in getting banks to build up capital against market declines than in trying to slow down financial innovation or the demand for high-yield products, said Douglas Elliott, a former JPMorgan managing director.
“We shouldn’t expect to deter people from doing something that they think will make them rich,” said Elliott, who now researches regulatory policy at the Brookings Institution in Washington. “If you are a business person, you are going to find a way to do that unless you are absolutely stopped.”
Still, he says regulators have to try because “we don’t have the ability to use interest-rate increases now to discourage excessive risk taking.”
Finding a way to combat bubbles is crucial after three rounds of asset purchases by the Fed -- designed to boost growth by encouraging investors to seek higher-yielding assets -- helped increase demand for junk debt. That’s a challenge Janet Yellen will face if she’s confirmed to replace Ben S. Bernanke as chairman. Yellen, currently vice chairman, will appear before the Senate Banking Committee tomorrow in the first step of the approval process.
There were $51.5 billion of inflows into U.S. bank-loan mutual funds this year through Sept. 30, compared with $11.1 billion in all of 2012, according to data from Morningstar Inc.
Fed policies have laid the groundwork for investors to take “excessive advantage of the low interest rates,” said Allan Meltzer, a professor of political economy at Carnegie Mellon University’s Tepper School of Business in Pittsburgh and the author of a history of the central bank. “They set up the conditions to encourage that and are going to get that result.”
Fed asset purchases have expanded its balance sheet to $3.85 trillion. The central bank is currently buying $85 billion of mortgage debt and Treasuries each month and is unlikely to slow the pace until March, according to the median response of 32 economists surveyed by Bloomberg News last week.
“We are still pushing risk for the sake of the economy as a whole,” Elliott said. “But it raises the danger that people will do stupid things.”
The Fed’s aggressive monetary stimulus “could lead to financial excess,” Sheila Bair, former FDIC Chairman, said in an interview. “When safe assets hardly return anything, people go farther and farther out on the risk curve.”
Companies have continued to pile on debt levels that approach or exceed the guidelines the Fed, the FDIC and the OCC outlined in March.
Dell Inc.’s debt to finance its acquisition by Silver Lake Management LLC and Michael Dell, including a $4.7 billion term loan, leaves the company with six times debt-to-EBITDA, a “high” debt level that will limit its financial flexibility as it faces “challenges” in the personal computer industry, Moody’s said in an Oct. 30 report. The loans are covenant-light.
Apax Partners financed its takeover of Rue21 Inc. with a $544 million term loan rated six levels above default that left the Warrendale, Pennsylvania-based teen-apparel retailer with debt-to-EBITDA of about eight times as of Aug. 3, according to an Oct. 1 Moody’s report. Leverage is likely to increase and remain elevated over the “near-to-intermediate term,” the report said.
Regulators’ actions in the leveraged-loan market show they may have learned their lessons from the subprime bubble, when unenforceable guidance failed to slow the boom in high-risk mortgage lending before the credit crisis.
“A static, sluggish regulatory process is one that we can’t afford anymore,” said Bair, now a senior adviser at Pew Charitable Trusts. “There are a lot of dollars out there chasing returns.”
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