Leveraged Lending Risk Still High Despite Progress, Fed Says

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  • Regulators say oil and gas-related credit increasingly weak
  • Nonbanks remain the primary buyers of high-risk loans

Leveraged lending by U.S. banks remains too risky, and credit tied to oil-and-gas exploration is getting weaker, according to a report by regulators including the Federal Reserve.

Bank examiners found that deals originated in the past year with a high level of borrowed money had weak structures. “Persistent structural deficiencies” in loan underwriting “warrant continued attention,” the regulators said.

The report, which covers 2014, underscores concern that risky behavior has become more commonplace as they seek to prevent a repeat of the loose lending that helped fuel the 2008 credit crisis. As regulators have focused on reducing risk at the largest banks and insurers, smaller firms have been playing a growing role in finance.

The review released Thursday by the Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency found flaws in financing in oil-and-gas exploration and production, following a slump in energy prices that started in mid-2014.

Loose Underwriting

The agencies noted a significant increase in lending volumes and continued loose underwriting in the more than $800 billion U.S. leveraged loan market, reflected by poor capital structures and provisions that limit lenders’ ability to manage risk.

Though there was some improvement in underwriting, flaws in leveraged lending deals drove an increase in so-called classified commitments -- those rated substandard, doubtful or as a loss. The amount of such loans in the energy sector quintupled to $34.2 billion. Credit quality deteriorated as oil prices tumbled 42 percent in the past year.

Nonbank companies continued to be the main buyers of “riskier, leveraged loans,” according to the report. While they owned the smallest share of the loan commitments analyzed, nonbanks owned 67 percent of the substandard ones, compared to 17.8 percent for U.S. banks.

Multi-firm Loans

The report, called the Shared National Credits Program 2015 Review, has been conducted by the agencies since 1977 to assess risk in the largest and most complex credits shared by multiple financial institutions. It analyzes multi-firm loans exceeding $20 million. Overall, commitments increased $518.3 billion last year to $3.9 trillion, a 15.3 percent increase from the previous period, the agencies said.

Leveraged loans make up 82.8 percent of all credit considered inadequate by regulators. Those loans are a type of high-yield debt typically issued by speculative-grade firms. Banks underwrite the financing and syndicate it to investors such as mutual funds and collateralized loan obligations.

Leveraged-loan issuance has dropped in the U.S. this year amid volatility tied in part to the commodities slump and continued pressure from regulators to curb risky underwriting. The $334 billion of loans sold to investors is down 32 percent from the same period last year, and 43 percent off the record pace seen in 2013, according to data compiled by Bloomberg.

Regulators said that incremental facilities -- a feature of a loan agreement that allows borrowers to increase debt beyond their starting leverage -- are “drawing attention.” The review found such “facilities have been used for dividends and other purposes that weaken the underlying credit fundamentals of the borrower.”