A dark corner of the financial market springs to life. Money piles in. Prices surge. Small investors clamor for a piece of the action. In the frenzy, risks are pushed aside. Have you seen this movie before? Regulators hunting for omens of another financial crisis are warning about a new debt bubble. They’ve sounded the alarm about the explosive growth in junk loans, which provide money for companies with shaky credit at higher interest rates. Banks call them leveraged loans, as borrowers typically are piling on debt, or leverage. Like their cousins junk bonds, junk loans are used by companies and private equity firms to do things like fund takeovers, pay shareholder dividends and refinance borrowings. Regulators trying to crack down on risky lending to protect the financial system were largely ignored. They had to step up scrutiny before the warnings began to sink in.
The craze emerged from the wreckage of the 2008 financial meltdown, as six years of record-low interest rates fueled demand for investments offering a higher return. Leveraged loans outstanding in the U.S. quadrupled in a decade to about $830 billion last year, topping the pre-crisis peak. By 2013, the binge had prompted the Federal Reserve and other U.S. regulators to suggest limits on how much debt a borrower can take on relative to earnings, to ensure that companies aren’t saddled with debts they can’t repay. The deals continued, though the threat of punitive action from regulators and fading demand in 2014 slowed the pace of borrowing, with big banks choosing not to participate in some risky leveraged buyouts. The other big worry is that small investors who piled into mutual and exchange-traded funds that bought high-yield loans may find it difficult to get their money out if the market sours. In 2014, they snapped a record 95 straight weeks of contributions to U.S. loan funds and started making redemptions. Leveraged loans are also on the rise outside the U.S., though the market is smaller and more of the debt is retained by banks. The Bank of England said in December it will review the risks.
Investors sometimes prefer loans to bonds because they offer payments tied to floating benchmark rates, so loan holders benefit when rates rise. If the borrower defaults, high-yield loans are likely to recover more money than junk bonds, a form of financing pioneered by Michael Milken that fueled leveraged buyouts during the 1980s. Loans can be underwritten by firms outside the purview of banking regulators, a form of shadow banking. There is no direct oversight of the loan market in the U.S., a situation that stems from securities laws from the 1930s, when loans were mainly private transactions between a single bank and a borrower. Nowadays, banks arranging loans sell them to pension managers, mutual funds and hedge funds. Unlike bonds, loans aren’t public securities and it can take weeks to complete a trade. They also get bundled into collateralized loan obligations, which repackage the debt into securities of varying risk and return. Rules to protect buyers of those instruments were introduced in Europe in 2011 and will go into effect in the U.S. in 2016. Similar securities that pooled subprime mortgages were blamed for triggering the 2008 financial crisis when the U.S. housing bubble burst.
As the U.S. Federal Reserve prepares to raise interest rates for the first time since the financial crisis, leveraged loans will provide an important test of whether the system can manage risk better. Loading too much debt onto companies can lead to busts that hurt shareholders, lenders and employees. Money managers who buy junk loans say they know how to tell the good deals from the bad ones. Mutual funds have lined up credit lines to help meet any surge in redemption requests if buyers flee. Even so, the furious expansion in leveraged loans increases the magnitude of potential losses, prompting watchdogs to ratchet up oversight of bank lending and consider whether they’ve done enough to apply the brakes.
The Reference Shelf
- Bloomberg Brief report on leveraged capital in 2014.
- U.S. Federal Reserve Governor Jerome Powell spoke about the risks from leveraged loans in a speech in February 2015.
- The Fed’s March 2013 guidance on leveraged lending.
- The Bank of England’s December 2014 Financial Stability Report.
First published Feb. 23, 2015
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Leah Harrison at email@example.com