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October 31, 2017

Wall Street Banks Cheering for the Record Surge in Riskiest Loans


By Wolf Richter, Wolf Street  

Crackdown efforts by bank regulators are put on hold.

The volume of leveraged loans – the riskiest loans Wall Street banks provide – has surged 38% year-over-year and has already beaten the full-year record set in 2013, according to Dealogic. Total of leveraged loans outstanding has reached $1.25 trillion.

Nine of the 10 largest banks in the leveraged-loan business have already surpassed their respective 2016 full-year totals, according to Bloomberg data, cited by the Financial Times, including Bank of America (about $120 billion in leveraged loans so far this year); JP Morgan (about $110 billion), Goldman Sachs ($79 billion); and Barclays ($72 billion). Of the top ten, only Wells Fargo ($69 billion) is still lagging behind last year.

The fees that the banks are raking for putting these loans together are also record-breaking: $8.3 billion so far this year, just 6% below the full-year total of 2016.

The borrowers are junk-rated over-indebted companies. Leveraged loans are too risky for banks to keep on their balance sheet. So banks structure these loans, arrange them, and sell the structured products to loan mutual funds or ETFs so that they can be moved into retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.

Leveraged loans are bought and sold like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them.

Since 2013, bank regulators – the Fed, the OCC, and the FDIC – have been exhorting banks to be prudent with leveraged loans, and they’ve been trying to crack down on leveraged lending because banks got stuck with these loans during the Financial Crisis. But that crackdown – however ineffectual it might have been – is now on hold because earlier this month, the Government Accountability Office questioned the legality of the standards set by the regulators.

And given the big-fat fees – potentially hitting $10 billion this year – banks are in no mood of cutting back.

But it’s not new loans that are booming. Companies aren’t borrowing that much. In fact there’s a dearth of new loans, given the feverish demand for them. The surge in leveraged loans is instead driven by companies that are renegotiating and refinancing existing loans to lower interest rates, accounting for over 60% of the total leveraged-loan issuance this year.

This is possible because credit markets have gone nuts in their all-out ferocious hunt for yield. There is so much demand from investors for these slightly higher yielding products that companies have the upper hand in setting the price.

“Net new supply is relatively low so demand is exceeding supply,” Christina Padgett, an analyst at Moody’s, told the Financial Times. “Investors are going to get squeezed on price and the issuers are going to take advantage so they have really flexible credit agreements.”

Leveraged loans are used to fund mergers and acquisitions; they’re a big financial tool for private equity firms. Their over-indebted junk-rated portfolio companies issue leveraged loans to fund the leveraged buyout, or to fund a special dividend back to the PE firm. But now the big thing is refinancing existing loans with even cheaper new loans.

“Transactions can get financed at very attractive levels,” Christina Minnis, global head of acquisition finance at Goldman Sachs, told the Financial Times. Year-over-year, Goldman has more than doubled its leveraged-loan book. “It’s booming,” she said.

In an environment where central banks have crushed yields, investors have become so desperate for any yield they can get, no matter what the risks, that borrowers are totally taking advantage of this desperation. Not only are leveraged-loan yields bouncing along record lows, but the investor protections written into the loan covenants have deteriorated to the point where “covenant quality,” as measured by the FridsonVision series, has reached a record low in the third quarter (chart below).


These “covenant lite” loans made up 82% of all leveraged loans in the first half of October, according to LCD. As of September 30, 73% of all US leveraged loans outstanding had a covenant-lite structure, the highest proportion ever. So investors are going to be in for a rough time when the tide turns, and they realize that customary protections are lacking.

Most of the brick-and-mortar retailers that have filed for bankruptcy protection over the past two years have been owned by PE firms, including Toys ‘R’ Us. Part of how PE firms make money is by stripping capital out of their portfolio companies via special dividends funded by leveraged loans.

Courtesy of Wolf Richter, Wolf Street

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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