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 have warned 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, leveraged loans are used by companies and private equity firms to do things like fund buyouts, pay shareholder dividends and refinance borrowings. Regulators have tried to crack down because they feared the rapid expansion in riskier lending magnified the potential for losses.
President Donald Trump plans to ease restrictions that curbed lending by regulated banks and made dealmaking more difficult. The move would put the U.S. at odds with Europe, which is tightening rules. The leveraged loan craze emerged from the wreckage of the 2008 financial meltdown, as years of record-low interest rates fueled demand for investments offering a higher return. Leveraged loans outstanding in the U.S. more than doubled from 2007 to a record $930 billion by mid-2017. The binge prompted the Federal Reserve and other U.S. regulators to suggest limits in 2013 on how much debt a borrower can take on relative to earnings to ensure companies weren’t saddled with debts they couldn’t repay. Big banks then chose not to participate in some risky leveraged buyouts, though a breed of non-bank lenders known as shadow banks stepped in to fill the void. Part of the 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. 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.
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. 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, hedge funds and ETFs. Unlike bonds, loans aren’t public securities and it can take weeks to complete a trade. The biggest buyers are firms that repackage the loans into collateralized loan obligations, securities that can have varying risk and return. Rules to protect buyers of those instruments were introduced in Europe in 2011. Similar restrictions went into effect in the U.S. in 2016, though they're being reviewed for a potential repeal under Trump. 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 raises interest rates, leveraged loans provide an important test of whether the post-crisis system can better manage risk. Loading too much debt onto companies can lead to busts that hurt shareholders, lenders and employees. Money managers who buy leveraged loans say they know how to tell the good deals from the bad ones and don’t need government oversight. Mutual funds that buy the loans 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 some watchdogs to consider whether they’ve done enough to apply the brakes.
The Reference Shelf
- Trump's promise to ease regulation offers a reprieve for banks, writes Bloomberg Gadfly columnist Gillian Tan.
- Association for Financial Markets in Europe report on leveraged finance.
- Federal Reserve Bank of New York paper on lessons from leveraged lending guidance.
- 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.
First published Feb. 23, 2015
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