Is a leveraged lending crisis imminent? Depends who you ask
WASHINGTON — Concerns about leveraged lending risks are still just academic, but a vigorous debate about the threat posed by corporate credit is already in high gear.
Commentators, Democratic lawmakers and other observers are increasingly sounding the alarm that growth in credit to highly leveraged firms could spur the next crisis. But large financial institutions, GOP lawmakers and even Trump-appointed regulators counter that the risk of leveraged lending losses triggering a 2008-like downturn is still remote.
"We must consider the possibility that" leveraged loans are a systemic problem, said Rep. Gregory Meeks of New York, the chairman of the House Financial Services subcommittee on consumer protection and financial institutions.
Both sides were on full display Tuesday during a hearing before subcommittee, which heard from witnesses urging the financial services industry and policymakers to act now to avoid potential systemic shocks. Meeks noted that the issue has appeared to demand the attention of the Financial Stability Oversight Council, which discussed leveraged lending at a closed-door meeting last week.
"Because of their explosive growth and rapidly eroding underwriting standards, leveraged loans have increased vulnerability in the financial system. In an economic downturn, this vulnerability has the potential to disrupt the availability of credit and reduce economic output," Gaurav Vasisht, senior vice president of the Volcker Alliance, said in testimony prepared for the consumer protection and financial institutions subcommittee. "To address this weakness, regulators should take the necessary steps to better understand and mitigate the risks of this complex market."
But GOP members pumped the brakes, echoing concerns by many that leveraged lending risks are being overblown. They note that the commercial banking sector is shielded from a direct hit, since most of the leveraged lending risk is in the nonbank sector, and financial firms have built up capital since the 2008 crisis to be able to absorb losses.
Rep. Blaine Luetkemeyer, R-Mo., the subcommittee's ranking member, said regulators should still monitor developments in leveraged lending, but that systemic concerns are mitigated when one considers that banks hold less than 8% of leveraged loans.
“This evidence suggests little systemic risk to our financial markets,” Luetkemeyer said in his opening remarks at Tuesday's hearing.
Greg Nini, a finance professor at Drexel University, agreed with the current consensus among regulators that leveraged lending does not pose systemic risks.
“The leveraged loan market does not seem to generate unique sources of systemic risk,” Nini said in prepared testimony. He added that collateralized loan obligations, the securitization instrument used to pool leveraged loans, "have stable sources of funding, and leveraged loan borrowers have widespread access to capital markets."
But Erik Gerding, a professor at University of Colorado Law School, warned that the "regulated financial sector is ... exposed to the risk of leveraged loans" since CLOs have similar characteristics to the complex investment vehicles that suffered massive losses in the mortgage meltdown.
"CLOs are close cousins of the mortgage-related collateralized debt obligations ... that were at the heart of the global financial crisis 11 years ago," he said.
Yet the banking industry too suggests that the risk is being exaggerated.
Ahead of Tuesday’s hearing, Greg Baer, the chief executive of the Bank Policy Institute, wrote in a blog post that even if leveraged lending has systemic implications, restricting the financial sector's ability to provide credit would be misguided.
"Almost daily, commentators now express concerns about leveraged loans as a source of macroeconomic risk, and perhaps a potential future crisis," Baer wrote. "Leaving aside whether that diagnosis is correct (and there are many reasons to believe it is not), the prescriptions being offered appear wildly inappropriate for that diagnosis."
Rather than restricting which loans banks can make or requiring more capital be set aside, Baer said, policymakers should set limits on how much companies can borrow.
“It is a borrowing problem, not a lending problem, and the most direct and effective response would be to limit the leverage of American companies, large and small — say, by prohibiting a company from borrowing more than some multiple of its earnings,” Baer said.
Rep. Andy Barr, R-Ky., said unlike the liquidity runs that followed the asset losses in the 2008 crisis, CLOs are intended to more stable.
“CLOs are long-term capital," he said. "They’re not subject to short-term redemptions or outflows, and in this regard, CLOs provide a vital source of liquidity in a downturn. This is exactly the type of structure that policymakers should want. … Overregulation of CLOs would be an impediment to financial stability.”
But Bill Foster, D-Ill., countered that instruments touted as fail-safe leading up to the crisis proved to be susceptible to huge losses.
“You are probably seeing pretty clearly the difference between members that were there in this committee during the financial crisis and those that heard a rather different after-the-fact rewrite of it,” Foster said. “Many, many previously safe financial products became unsafe during that crisis. … Very few people had a clear idea.”
Globally, new issuance of leveraged loans hit a record of $788 billion in 2017, surpassing the pre-crisis high of $762 billion in 2007, according to a House Financial Services Committee memo. The U.S. had by far the largest leveraged loan market last year, accounting for $564 billion of new loans.
Regulators’ most recent Shared National Credit report, which reviews the status of the industry’s syndicated loan portfolio, said leveraged lending risk is “building in contrast to the portfolio overall.”
The federal bank regulators have flagged risks associated with leveraged lending for years, but senior officials, to some degree, have downplayed those risks posed to commercial banks since most of the asset growth has been at nonbanks. Last year, Comptroller of the Currency Joseph Otting notably said banks “really kind of stayed on the rails” in leveraged lending.
Last month, Federal Reserve Board Chairman Jerome Powell said the financial system can withstand losses from business debt concerns.
“In public discussion of this issue, views seem to range from ‘This is a rerun of the subprime mortgage crisis’ to ‘Nothing to worry about here,’ ” Powell said. “At the moment, the truth is likely somewhere in the middle.”
Yet the agencies still point to heightened risks. A December report by the Office of the Comptroller of the Currency on risks in the industry said “deterioration in corporate bond and loan markets may affect supervised institutions more profoundly than in previous periods.”
“In this environment where there are very high and elevated leverage levels being done outside the banking industry, it’s important for banks to look at a company’s suppliers or a company’s distribution network and understanding the leverage levels that are important partners in executing their business plan,” Otting said when the risk report was released.
But Gerding criticized a decision by the OCC last year to stop enforcing the bank regulators' 2013 interagency guidance on leveraged lending. The agency's decision followed a finding by the Government Accountability Office that the guidance was effectively void because it should have been issued as a formal rulemaking under the Congressional Review Act.
“The comptroller’s decision degraded the ability of federal regulators to monitor the buildup of risk in the leveraged loan market — and, by extension, the CLO market which securitizes those loans — and banks’ exposure to that risk," Gerding said.