Banks heed regulators’ concerns on US leveraged loans

• Regulators step up scrutinty of leveraged loans

• Move may put brakes on $1 trln-a-year market

• Banks may lend less

US regulators are keeping closer tabs on how banks are managing the high-risk lending that triggered the financial crisis, including leveraged loans financing acquisitions and dividend payments.

This could force banks to lend less and trigger a slowdown in the $1 trillion-a-year US leveraged loan market, which is experiencing frothy and aggressive conditions last seen at the peak of the market in 2007.

“The result is that they (banks) are going to be able to lend less money,” said Brett Barragate, co-head of the banking and finance practice at Jones Day.

Banks are categorising the loans on their books to determine how each will be treated under the new guidelines and assess the consequences for future lending, sources said.

US banking regulators including the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp sent an advisory in March outlining target underwriting criteria, including leverage ratios and a timeline for debt repayment.

This was followed with letters to arranging banks in the fall and regulators have repeatedly warned that underwriting standards are weaker.

The US leveraged loan market, which has been helping companies to cut borrowing costs by repricing and refinancing existing loans, is on heightened alert that banks could be able to lend less, which could curb already weak economic activity.

“I’ve heard from two banks in the last 24 hours that it could start to have an impact on their business on the arranging side,” a senior London-based banker said.

The spotlight sharpened after federal agencies said in October that leveraged loans accounted for most of the “criticised” assets in bank and non-bank portfolios.

The credit quality of banks’ large syndicated loan commitments was little changed from last year but examiners criticised 42 percent of the leveraged loan portfolio, regulators said in a 2013 Shared National Credits (SNC) annual review.

Under March’s leveraged lending guidance, loans may be criticised for repayment risk if a company fails to show the ability to amortise all senior debt or half of total debt from free cash flow within five to seven years.

Top on the hit list of regulatory concerns are: excessive leverage, inability to amortise debt over a reasonable period and a lack of meaningful financial covenants.

The volume of issuer-friendly covenant-lite loans hit a record $221 billion this year, with another $12 billion in the pipeline. This far exceeds $84 billion of covenant lite loans in 2012 and the previous record of $108 billion in 2007, Thomson Reuters LPC data shows.

Regulators expressed concern about the quality of underwriting in leveraged loans, particularly higher leverage and loose covenants in the recent letters to banks.

“They have asked what procedures banks have in place. It’s impossible to see how this will play out.” a senior US leveraged finance banker said.

In an October report on “shadow banking”, the New York Fed noted that entities not subject to traditional bank regulation are stepping up lending to low-rated companies at the same time that individuals are buying the riskier loans.

Retail investors have poured money into loan mutual funds for 75 straight weeks, seeking higher-yielding assets as Fed policy keeps interest rates at rock-bottom levels.

Most leveraged loans are however bought by Collateralised Loan Obligation (CLO) funds and other institutional investors.

And recovery rates on leveraged loans are high relative to bonds, while net new issuance is relatively flat with pre-crisis levels, the New York Fed noted.

“It’s important that there is a distinction made between the moms and pops that were sold dodgy real estate loans, and who we are selling to in the leveraged finance market – sophisticated asset managers,” another senior leverage finance banker said.

Lynn Adler is a senior reporter for RLPC in New York