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Treasury Warns Congress (and Investors): This Financial Creature Could Sink the System

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Wolf Richter   www.wolfstreet.com   www.amazon.com/author/wolfrichter

In its 2014 Annual Report to Congress, the US Treasury's Office of Financial Research, which serves the Financial Stability Oversight Council, analyzed for our Representatives the “potential threats” to the US financial house of cards. Among the biggest concerns was a financial creature that has boomed in recent years. The Fed, FDIC, and OCC have warned banks about it since March 2013. But they’re just too juicy: “leveraged loans.”

Leveraged loans are issued by junk-rated corporations already burdened by a large load of debt. Banks can retain these loans on their balance sheets or sell them. They can repackage them into synthetic securities called Collateralized Loan Obligations (CLOs) before they sell them. They have “Financial Crisis” stamped all over them.

So the 160-page report laments:

The leveraged lending market provides a test case of the current approach to cyclical excesses. The response to these issues has been led by bank regulators, who regulate the largest institutions that originate leveraged loans, often for sale to asset managers through various instruments. Despite stronger supervisory guidance and other actions, excesses in this market show little evidence of easing.

How did we get here?

Relentless QE along with interest-rate repression by the Fed and other central banks – “accommodative global monetary policy,” the report calls it – caused changes in “risk sentiment,” compressed volatility, and reduced risk premiums. To get a visible yield in an environment where central banks wiped out any visible yield, investors were “encouraged” to take on more and more risk, even for their most conservative holdings, thus moving “out of money market instruments and into riskier assets such as leveraged loans….”

During the “bout of volatility” in September and October, investors sold off these creatures, but it wasn’t nearly enough to dent the vast positions they’d accumulated. “On the contrary,” the report pointed out, “the fleeting nature of the episode ultimately had the effect of reinforcing demand for duration, credit, and liquidity risk, and led many investors to reestablish such positions.”

This came at the wrong time.

The credit cycle has four phases: repair (balance-sheet cleansing), recovery (restructuring), expansion (increasing leverage, weakening lending conditions, diminishing cash buffers), and finally the downturn (funding pressures, falling asset prices, increased defaults). Now the US is “somewhere between the expansion and downturn phases.”

Nonfinancial corporate balance-sheet leverage is still rising, underwriting standards continue to weaken, and an increasing share of corporate credit risk is being distributed through market-based financing vehicles that are exposed to redemption and refinancing risk.

Financial engineering has taken over.

Early on in the credit cycle, corporations borrowed money long-term to replace short-term debt and to fund capital expenditures. Now they use the borrowed money to “increase leverage such as through stock buybacks, dividend increases, mergers and acquisitions, and leveraged buyouts, rather than to support business growth.” And ultra-low interest rates and loosey-goosey lending standards have encouraged corporations to take “on more debt than they can service.”

So the ratio of debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) for the most highly leveraged loans reached 7.7 in October, near the peak in 2007, at the cusp of the Financial Crisis. Large corporate loans with leverage ratios above the regulatory red-line of 6 times EBITDA soared from 15% of corporate bank loans, back when regulators started warning banks about them, to nearly 30% in 2014, exceeding the record set in 2007 before it all went down the tubes:

US-OFR-leveraged-loans-leverage-6x-ebitda

Why would that be a problem? Because…. “Even an average rate of default could lead to outsized losses once interest rates normalize.”

And the quality of the debt sucks.

Junk debt accounts for 24% of all corporate debt issued since 2008, up from 14% in prior cycles. Over the past year, junk debt “dominated new issuance volumes.” And ominously for the holders of this debt:  Two-thirds of these loans during the current credit cycle lack strict legal covenants to protect lenders, compared to one-third in previous cycles. Once the tsunami of defaults sets in during the downturn, these “covenant lite” loans will lead to lower recovery rates on defaulted debt, thus increasing the losses further.

This chart (2014 data through September, annualized) shows how volume of “highly leveraged loans” (those with a spread of 225 basis points above LIBOR), at nearly $600 billion this year, is about 50% higher than it was at the cusp of the Financial Crisis. And the dreaded covenant-lite loans, oh my:

US-OFR-leveraged-loans-cov-lite_highly-leveraged

Now enter CLOs.

The combined issuance of CLOs and leveraged loans has exceeded the peak levels of the last credit cycle, whose downturn phase turned into the Financial Crisis. This buildup in credit risk has frazzled bank regulators, and they have responded harshly, the OFR reported, um, “with guidance and exhortations.”

It may be too little, too late. As the credit cycle enters the downturn phase with the deterioration in corporate credit fundamentals and rising debt levels, “the buildup of past excesses will eventually lead to future defaults and losses.”

But we’re not there, yet.

Yields on leveraged loans and junk bonds, and spreads per unit of leverage, are still at historic lows, the OFR found (though some of it has very recently gone to heck, especially in the energy sector). And “investors are not being compensated for the incremental increase in corporate leverage.”

The increased credit, liquidity, and volatility risks – that “tend to rise simultaneously during periods of stress” – have led to these junk loans being wildly “mispriced.” When they’re repriced during the downturn, investors will lose their shirts.

And “product innovation” has soared, another “hallmark of late-stage credit cycles.” They led to “broader, cheaper access to credit such as exchange-traded, high-yield, and leveraged loan funds; total return swaps on leveraged loans; and synthetic collateralized debt obligations (CDOs).”

Banks, after originating these leveraged loans and repackaging them, increasingly sell them to nonbank lenders, such as institutional investors, pension funds, insurance companies, finance companies, mutual funds, ETF, etc. This process started long before the Financial Crisis – manifested by the collapse and occasional bailout of nonbanks, such as AIG. This chart (data through June 2014) shows this trend of risk being sloughed off to others:

US-OFR-leveraged-loans-banks-v-nonbanks

The problem with nonbanks?

They’re not regulated by banking regulators. Even if the Fed, the FDIC, and the OCC crack down on banks with regards to leveraged loans, there is little they can do about nonbanks. And pushed to desperation by the Fed’s near-zero interest rates, nonbanks “engage in riskier deals than banks….”

Short-duration funds, which invest in leveraged loans, have shown the most significant growth. Assets under management have increased ten-fold over the last five years, driven by a search for yield and a hedge against an eventual rise in interest rates.

But banks can still be at risk when “a sudden stop in the leveraged lending market” – for example, when investors in ETFs and mutual funds get spooked – forces banks that originated these leveraged loans to hang on to them.

Yet a “significant amount of this risk continues to migrate to asset management products,” including mutual funds and ETFs that people have in their retirement funds. And investors in these products are largely on their own. When redemptions and fire sales start cascading thorough the system – the dreaded “structural vulnerabilities” – all heck could once again break loose. And that “adds urgency to the discussion” of how “a poorly underwritten leveraged loan that is pooled with other loans or is participated with other institutions may generate risks for the financial system.” Not to mention how it will savage the retirement portfolios of unsuspecting retail investors.

And some of this has already started happening in the energy sector. Revenues are plunging. Earnings will get hit. Liquidity is drying up. And stocks got eviscerated. Read…  Oil and Gas Bloodbath Spreads to Junk Bonds, Leveraged Loans. Defaults Next  

 

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Tue, 12/09/2014 - 15:19 | 5533691 Shitgum Suicide
Shitgum Suicide's picture

The whole process of financial collapse is to taint every aspect, including government employees who depend on pensions and benefits, so that the only thing that anyone can turn to is government.

2008 was the build up of government home loans and forced lower lending standards on banks to give to dumb Americans who didn't question anything the "American dream."
The bad debt that was known about and knew the outcome, see Dr. Michael Bury, would collapse the ability to afford your home anymore that the banks would own them via government bailouts. The next leg is the monetary collapse to complete the control.
Call it what you will. Cloward Piven seems to be the objective. What was the objective? Destroying capitalism and the United States.

Tue, 12/09/2014 - 15:16 | 5533677 moneybots
moneybots's picture

Financial engineering And “product innovation”

 

Euphemisms for financial fraud.

Tue, 12/09/2014 - 14:33 | 5533454 rlouis
rlouis's picture

"Banks, after originating these leveraged loans and repackaging them, increasingly sell them to nonbank lenders, such as institutional investors, pension funds, insurance companies, finance companies, mutual funds, ETF, etc."

 

I can't wait for the endless lawsuits and financial settlements that follow the collapse of this fraud.  puke

Tue, 12/09/2014 - 13:58 | 5533250 silentboom
silentboom's picture

I don't think Americans will see this information unless we write it across Katy Perry's bouncing tits or Nikki Menage's enourmous ass.

Tue, 12/09/2014 - 14:33 | 5533453 Mi Naem
Mi Naem's picture

"Katy Perry...or Nikki Menage

Do they work for CNBC, maybe replacing that chick with big eyes and too much makup that thought Jamie Dimon walks on water? 

Tue, 12/09/2014 - 13:50 | 5533219 TheGreatRecovery
TheGreatRecovery's picture

"Financial engineering" is an oxymoron.  Engineers are licensed to protect public health, safety, and property.  "Financial engineers" apparently work on teams which seek to exploit technological loopholes to steal from the public.  Such theft obviously endangers public health, safety, and property.

Tue, 12/09/2014 - 13:43 | 5533186 Gern Blanston
Gern Blanston's picture

"compressed volatility"...

Reading that term conjured an image of a very old toy called a "jack-in-the-box"...

Tue, 12/09/2014 - 13:32 | 5532903 ebworthen
ebworthen's picture

So now really is the best time to buy a home?

Or a new car, or go back to college!

CDO, MBS, derivative bliss!

100X leverage karma!

Tue, 12/09/2014 - 11:34 | 5532547 rsnoble
rsnoble's picture

Hard to tell what will happen because the stock market is now a matter of national securtity which means anything goes and all laws are null and void.

Tue, 12/09/2014 - 10:02 | 5532094 Panic Mode
Panic Mode's picture

So do we print more to justify that???

Tue, 12/09/2014 - 14:34 | 5533463 Mi Naem
Mi Naem's picture

"print more

Seems to be the correct answer to all questions that don't involve militarized police intervention, and some of those that do. 

Tue, 12/09/2014 - 10:00 | 5532086 spinone
spinone's picture

Don't worry about the banks.  They'll be bailed out of their bad debts again, just like last time.

Tue, 12/09/2014 - 14:37 | 5533480 Mi Naem
Mi Naem's picture

'cept this time it won't be stolen from future taxpayers' salaries. 

It will be stolen from current taxpayers retirement funds. 

Tue, 12/09/2014 - 09:52 | 5532062 Duc888
Duc888's picture

 

 

 

Sounds like another Shit Sandwich to me.  The banks are a veritable buffet of shit sandwiches, chunky shit, runny shit, semi solid shit, but all shit all the time.

 

Tho only thing that still has me guessing is WHO will be taking the blame for this when the shit sandwiches slides off the plate.

Tue, 12/09/2014 - 12:12 | 5532709 TheReplacement
TheReplacement's picture

Russell Simmons says nothing to worry about here.  No blame will even need to be assigned.  The coming race war (protests) will cover everything.

Tue, 12/09/2014 - 09:48 | 5532041 q99x2
q99x2's picture

The old problem of trying to make something out of nothing like God did with Q99X2; and still finds difficulty with. But no matter. When put in front of one another there is a mirror behind every other mirror. This too shall pass.

Tue, 12/09/2014 - 09:22 | 5531944 AdvancingTime
AdvancingTime's picture

This is one of the problems with low interest rates and easy money, it increases the willingness to take on risk in return for higher yields. When an economy is growing rapidly, there is generally an abundance of profitable investment opportunities and businesses are happy to borrow at high real rates. In a sense, then, the level of real interest rates sets a hurdle by which profitable projects should be judged.

If the rate is held at an artificially low level for too long, a big danger is that capital may be misallocated and flow into speculative investments. A recent report from the Bank for International Settlements points to a number of other problems that negative real rates can cause such as tempting borrowers into ignoring their balance-sheet problems. The article below delves into the dark-side of lower interest rates.

 http://brucewilds.blogspot.com/2013/03/low-interest-rates-and-their-cost.html

Tue, 12/09/2014 - 09:12 | 5531928 Ban KKiller
Ban KKiller's picture

Are we blaming immigrants or millennials? No, fat or super fit white guys! Banksters!

Tue, 12/09/2014 - 09:00 | 5531899 RECISION
RECISION's picture

UNSUSPECTING... ???

Good grief - give me a break...

Tue, 12/09/2014 - 08:55 | 5531876 amanfromMars
amanfromMars's picture

Move along now, please. Nothing much to see here, but a heck of a lot more than just hot air to think about, for it is gospel truth and not at all nonsense.

amanfromMars [1412091219] sharing a current view and future trend on http://thedailybell.com/news-analysis/35896/Economist-Magazine-Explains-Why-Economics-Is-Prestigious--But-Gets-It-Wrong/

 

What has been emphasized most particularly is the role of the "expert" – someone who can basically predict future trends in any one of a number of areas and industries.

 

Accompanying the cult of the expert has been an explosion of think tanks, doctoral programs and publishing facilities designed to celebrate those who provide credibility to the meme of predictive knowledge. 

 

I wouldn’t dream of being pretentious and acknowledge any expertise in anything but the future is being decided upon on strange bases indeed and manufactured by the following, with those and/or that well versed in the methodology way out ahead in front and surprising the rear, and practically leading from afar, virtually untouchable and unstoppable. A fabulous fact and fanciful fiction and quantum leap communication.

 

The improbable and impossibly surreal nature of existence without media related tall tales and twisting trails to engage in the mind meddling and melding with thought control and future directional flow of perception of the masses of the newly born ignorant and arrogant undereducated beings, is that which drivers the current madnesses and secretly delivers Great IntelAIgent Games Futures with ITs Clouds Hosting Advanced Operating Systems.

 

And whenever you know that supposed rulers and systems administrations are being made perfectly aware of the dangers of their ignoring and/or misusing and abusing the facility and its controllers, be not surprised when old traditional conventional establishment systems collapse catastrophically and practically overnight. 

 

Now surely you didn't expect the future to be anything like the present and the past whenever it was/is so dysfunctional and rigged.

Tue, 12/09/2014 - 08:36 | 5531838 Comte d'herblay
Tue, 12/09/2014 - 08:24 | 5531811 Racer
Racer's picture

They didn't bother to fix it the last time, since then bankster criminality gets tiny wrist slap punishments. So there is no incentive whatsoever to change behaviour when the rewards are so high

Tue, 12/09/2014 - 10:32 | 5532228 RaceToTheBottom
RaceToTheBottom's picture

Actually based on Bankster rewards, you would be batshit crazy NOT to continue cheating.

Tue, 12/09/2014 - 02:32 | 5531563 USisCorrupt
USisCorrupt's picture

Where's the problem again?

 

Moar Bullish !

Tue, 12/09/2014 - 09:46 | 5532039 TwoHoot
TwoHoot's picture

The problem is in the $quadrillion derivative market counter-party risk.

Tue, 12/09/2014 - 12:30 | 5532794 A Nanny Moose
A Nanny Moose's picture

Yup. Meantime Congress conducts moar 36 hr news cycle, dog and pony shows, over CIA Torture and Goobergate.

Tue, 12/09/2014 - 15:30 | 5533737 Shitgum Suicide
Shitgum Suicide's picture

Actually the CIA torture pony show is to cover for gruber. Know how I know? What is the media focusing on gruber or the "torture" bs.

And before anyone slams me for torture and not giving a flying fuck about those captured on the battle field you need to remember just one thing about international law and the Geneva convention. The terrorists/extremists/Isis are not a standing army of any recognized nation.
Did those pirates off the coast of Somalia get their Geneva convention?

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