Update 349 — Today’s Leveraged Loan Market:
Animal Spirits or 2020 Recessionary Canary?
The leveraged loan market may not sound like a factor in the 2020 elections, but 18 months before the 2008 election, leverage was already off the dial, Wall Street was booming, and no one predicted the economic or electoral consequences. Odds that leveraged loans will assume a systemic degree of danger and tank the economy are remote. Again.
By the way, a front-page NY Times article today is Exhibit A for the O-Zone headline risks investors (and taxpayers) run without adequate protections. Earlier this week, we wrote about the risks run by investors in the administration’s Opportunity Zone program lacking a broad financial protections title.
Leveraged loans are extended to companies that already have considerable amounts of debt and/or a poor credit history, issued with the promise of superior returns. Firms use leveraged loans to buy new assets, recapitalize their balance sheets, refinance debt, or simply for general corporate purposes. The US leveraged lending market has grown to over $2 trillion outstanding, up about 80 percent since 2011.
Ultra-low interest rates, return-hungry investors, and a booming US economy have fueled this growth in a market that now surpasses the junk-bond market as a source of borrowing for highly indebted companies with poor credit. Not all corporate debt is bad debt, but leveraged loans are inherently risky due to the nature of the borrower. Some draw parallels with the subprime mortgage market that precipitated the Great Recession.
How substantial is the risk, and what can Congress and regulators do about it?
Systemic Risk Dangers
At an April 10 House Financial Services hearing featuring seven CEOs of the eight Global Systemically Important Banks (G-SIBs), Rep. Jim Himes asked the witnesses what is generating systemic risk within markets. Almost all seven witnesses brought up leveraged loans — especially those loans generated outside the traditional banking framework. Information on these loans is difficult to monitor, in part because leveraged loans are private and their transactions data enjoy privacy rights.
Those concerned about systemic risk point to “covenant-lite” loans taking over the leveraged loans market. As recently as February, 85 percent of all leveraged loans were considered “covenant-lite,” which means that they lack traditional requirements for companies to maintain certain financial benchmarks that protect the investors who pay for them.
Source: Business Insider
The predominance of nonbank leverage loan activity is worrisome because these loans are subject to patchwork regulation and oversight. Traditional lenders today seek to regain market share by underwriting more leveraged loans and purchasing more and more collateralized loan obligations, many of which contain leveraged loans. Companies are also maintaining higher debt-to-earnings ratios. In a densely interconnected marketspace, echoes of the mid-2000’s housing bubble are apparent.
The Recessionary Canary?
The leveraged loan market has concerning parallels with the subprime mortgage market that led to the 2007-08 financial crisis. There are also differences, which make leveraged loans more of a sui generis market, but perhaps no less systemic.
Notable facets of the leveraged loan market:
- Low interest rates are fueling the boom: Low credit households were the target of lenders during the subprime mortgage crisis, but today low credit companies are binging on cheap debt. With low rates, the lack of monetary wiggle-room in a recession may mean that easing of rates will provide less benefit to markets than in past cycles.
- Loans tranches sliced, diced, sold again: One reason for the contagion during the subprime mortgage crisis was the trading of derivative instruments known as mortgage-backed securities, such as Collateralized Debt Obligations (CDOs). These instruments are similar in structure to the Collateralized Loan Obligations (CLOs) that package up these risky loans into “tranches” supposed to provide returns reflecting underlying loans. The value of outstanding CLOs has doubled since 2007.
- Loan underwriting now in the shadows: Due to regulator guidance on leveraged loans, banks have stepped back somewhat from underwriting these loans despite still being the largest leveraged loan underwriters in 2018. Today, non-bank entities, such as private equity groups, hedge funds, and even pension funds, originate loans mainly outside the scope of regulatory oversight.
- Lack of investor protections: In 2018, a third of all loans exceeded six times earnings before interest, tax, depreciation, and amortization (EBITDA), close to the 2007 peak and over the threshold for concern by US regulators. The covenant-lite nature of 80 percent of these leveraged loans means investors will have little recourse in the event the loans go sour. Higher leverage multiples, weaker covenants, and much larger add-backs suggest that future loan recoveries will likely be well below historic levels.
Little Less Conversation, a Little More Action?
An analytic choice between leveraged loans as a frothy animal-spirited financial market and one flashing a recessionary early warning sign is a false dichotomy. The relationship is more causal than concurrent.
Many argue that we are coming to the end of a long recovery and credit cycle. These highly leveraged companies will be most at risk should things turn, and the sheer scale of the market could risk contagion in the financial markets and in the real economy. Highly-levered companies and the investors who hold their debt could be in for a rude awakening as economic data softens or interest rates begins to rise. Many have acknowledged the potential risk, but will we heed the warning?