The Power of Collateralized Loan Obligations.
“The global leveraged loan market is larger than – and growing as quickly as – the US subprime mortgage market was in 2006,” said the Bank of England’s Financial Policy Committee in the statement from its latest meeting. And the committee is “concerned by the rapid growth of leveraged lending.”
In terms of magnitude, the US and EU “leveraged loan” market combined now exceeds $1.3 trillion, up from $50 billion at the turn of the century.
A “leveraged loan” is a loan that is extended to junk-rated (BB+ or lower), over-indebted companies. These loans are considered too risky for banks to keep on their books. Instead, banks sell them to loan funds, or they package them into highly rated Collateralized Loan Obligations (CLOs) and sell them to CLO funds and other institutional investors. In the UK, over £38 billion ($50 billion) of these loans were issued in 2017 — more double the amount in 2016 — and a further £30 billion ($39 billion) has already been issued in 2018.
Leveraged loans are popular among investors because of the slightly higher interest rates they offer, and because they’re often based on floating rates, a positive in an environment where interest rates are rising. Investors earn a set amount of interest — the so-called margin — on top of the prevailing Libor benchmark rate. As the Libor rises, so too does the interest. The loans’ floating interest rates offer investors some degree of protection from rising rates, until, of course, the borrower defaults.
While banks benefit from issuing leveraged loans via hefty fees for arrangement, structuring and portfolio management, since these loans are typically sliced, diced and sold in global financial markets in classic sub-prime fashion. Among the biggest buyers are CLO funds.
One of the myriad problems with this practice, warns the Bank of England, is the acute lack of certainty about investors’ “ability to sustain losses without materially impacting financing conditions.” But if things do go south, the resulting pain may nevertheless end up boomerang back to the banks.
“The borrowing they [the risk-chasing investors] do is usually from a bank,” Douglas Diamond, a finance professor at the University of Chicago Booth School of Business, recently told Bloomberg. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank — not necessarily the same bank. So the risk would ultimately get back to the bank balance sheets.”
Taking junk bonds and leveraged loans together, the estimated stock of debt outstanding in UK non-investment grade firms is estimated to account for around one-fifth of total UK corporate sector debt. There have been similar increases across Europe and in the US, the Bank of England’s Financial Policy Committee pointed out. Since 2012, the leveraged loan market in the U.S has doubled in size to $1.1 trillion.
It’s perhaps no surprise that the riskiest corporate loans are surging on both sides of the Atlantic at a time that the number of so-called “zombie companies” is also exploding, in large part due to the central banks’ low interest rate policies, which have allowed moribund firms to stay alive much longer than they would have under normal conditions.
The Bank of England is not the only financial regulator sounding the alarm bells about leveraged lending. The IMF voiced its reservations about the loan market in its global financial stability report in April. “Signs of late credit cycle dynamics are already emerging in the leveraged loan market and, in some cases, are reminiscent of past episodes of investor excesses,” it warned.
Then, a couple of weeks ago, the Bank of International Settlements (BIS) added its voice, cautioning that rising interest rates around the globe could cause distress among the heavily indebted borrowers that depend on leveraged loans. According to the BIS, the total value of leveraged loans and high-yield bonds outstanding in Europe and the U.S. has doubled to around $2.6 trillion since the global financial crisis.
As the market has grown, the lending terms have loosened. Maintenance covenants require a borrower to meet certain financial tests every reporting period, usually quarterly. This provides lenders with basic protection against default by allowing them to exercise some degree of control over a borrower’s behavior. But such covenants entail additional costs for investors and many investors would rather forego those costs in order to maximize their returns.
In the UK the proportion of leveraged loans with maintenance covenants has plunged from close to 100% in 2010 to around 20% currently. These are the infamous “covenant lite” or “cov lite” loans — in other words, about 80% of the leveraged loans are cov lite. A similar scenario is playing out in the US.
As criticism of this trend rises, banks have begun hitting back. Credit Suisse, one of the largest players in the $1.3 trillion market for leveraged loans, sent a confidential letter to clients in September attempting to dampen their fears. The letter was duly passed on to The Financial Times, which a few days ago shared its content with its readers.
While the bank acknowledged the mounting concern about the recent explosion of leveraged loans, it claimed the fears were overdone. It also stressed that forecasts for loan defaults are still below long-term averages and that one of the largest buyers of the securities were CLOs, vehicles that “do not become forced sellers and actually provide consistent, stabilizing demand for loans”. The growth in the size of the leveraged loan market has also slowed since the years before the Financial Crisis and is “hardly an indication of excess,” it wrote. As the third-largest US manager of CLOs, Credit Suisse has every incentive to downplay the risks arising in the leveraged loan market.