Regulators Caution Banks to Boost Standards on Leveraged Loans

Federal regulators issued new guidance on leveraged lending to combat weakening standards as issuance of the debt grows at the fastest pace since the financial crisis.

Prudent underwriting practices have deteriorated with the inclusion of covenant-light transactions and less-than-satisfactory risk management practices, according to a guidance today from the Federal Reserve, the Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency.

Speculative-grade borrowings such as leveraged loans have benefited from the Fed’s attempts to galvanize the economy by buying $85 billion in Treasury and mortgage debt, and holding its benchmark rate near zero since 2008. Speculative-grade rated borrowers obtained $113 billion in loans last month from non-bank lenders, exceeding the pre-crisis peak of $55 billion in April 2007, according to JPMorgan Chase & Co.

“An institution’s underwriting standards should clearly define expectations,” and should “consider whether the borrower’s capital structure is sustainable,” the agencies said in the statement. Banks’ risk-rating standard must make realistic assumptions, establish underwriting methods similar to those for internal loans and perform stress testing on loans held within its portfolio as well as those planned for distribution, according to the statement.

Covenant-Light Revival

Companies in the U.S. have received more than $25 billion of covenant-light loans in each of the first two months of the year, which compares with a February 2007 peak of $25.3 billion, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. The loans carry fewer safeguards such as limits on how much debt a company can add to its balance sheet.

Inflows into funds that invest in leveraged loans have climbed to $12.4 billion this year, which is greater than the total deposits into the funds in all of 2012, according to a March 15 report from JPMorgan.

Leveraged loans and high-yield, high-risk, or junk, bonds are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.

The Fed’s third round of so-called quantitative easing began in September and was boosted in December to $85 billion in monthly purchases. Fed Chairman Ben S. Bernanke calls the policy credit easing, and has said it works by forcing investors to seek higher yields in other securities.

Some Fed officials are concerned the policy may be fueling bubbles in some corners of the credit market. Bernanke in a news conference yesterday said that the Federal Open Market Committee considered at its two-day meeting this week “possible risks to financial stability, such as might arise if persistently low rates lead some participants to take on excessive risk in a reach for yield.”

Investors are paying an average of 98.19 cents on the dollar to buy pieces of leveraged loans, up from the record low 59.2 cents in December 2008, according to the S&P/LSTA U.S. Leveraged Loan Index. That’s the highest level since July 2007.

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