(Adds comments from Senate hearing in seventh paragraph.)
By Kristen Haunss
NEW YORK, Nov 15 (LPC) - US Senator Elizabeth Warren sent a letter to regulators Wednesday expressing concerns about underwriting standards in the leveraged loan market, which she says could pose serious risks to the economy.
In the letter, Warren questioned regulators on what their agencies’ plans are to address what she describes as “growing risks” in the leveraged lending market as well as proposed changes to rules governing the Collateralized Loan Obligation (CLO) market, the largest buyers of leveraged loans. She (Munich: SOQ.MU - news) requested responses by December 11.
“I am concerned that the large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market,” Warren wrote.
“These loans are generally poorly underwritten and include few protections for lenders and investors,” she wrote. “Many of the loans are securitized and sold to investors, spreading the risk of default throughout the system and allowing the loan originators to pass the risk of poor underwriting on to investors.”
The US$1.1trn US leveraged loan market, which finances companies including American Airlines (Frankfurt: A1W97M - news) and retailer Party City, has been flooded with aggressive deals featuring high debt levels and loose terms, just five years after regulators criticized those same features, concerned about the risks the debt posed to the financial system.
In the letter addressed to Treasury Secretary Steven Mnuchin, Joseph Otting, the Comptroller of the Currency, Jerome Powell, chairman of the Federal Reserve (Fed), Jay Clayton, chairman of the Securities and Exchange Commission, and Chair Jelena McWilliams of the Federal Deposit Insurance Corp, Warren noted the growth of the market and the increase of debt that lack full lender protections, known as covenant-lite loans.
During a Senate hearing Thursday, Warren questioned Randal Quarles, the Fed vice chair for supervision, about the leveraged lending market. The Fed will look carefully at leveraged lending during this supervisory cycle as well as how the CLO market is evolving, Quarles said, but noted that the guidance is not enforceable.
More than US$585bn of US institutional loans were arranged in the first three quarters of the year after a record US$923.8bn was issued in all of 2017, according to LPC data. In 2007, at the height of the pre-crisis buyout market, US$425.8bn of institutional loans were arranged.
Leverage for buyouts increased to 6.94 times in the third quarter, the highest level since the same three-month period in 2014, according to the data. About 73% of the leveraged institutional market in the first nine months of 2018 was covenant-lite.
Warren highlighted the floating-rate nature of the debt – a selling point for investors looking for a hedge to rising interest rates – and noted that additional rate hikes by the Fed could force companies to deal with rising interest costs as the economy slows down.
The Fed has raised rates eight times in the last three years.
Warren’s comments follow those from former Fed Chair Janet Yellen who said in a Financial Times interview that lending standards were falling. The Bank of England’s Financial Policy Committee has also sounded the alarm about the asset class.
Warren posed questions to each of the receivers, asking what the Financial Stability Oversight Council (FSOC) is doing to monitor the leveraged loan market and how regulators viewed requests to loosen the Volcker Rule for CLOs.
She also asked if the Office of Credit Ratings had found any evidence that leveraged loan and CLO ratings lack accuracy or are "unduly influenced" by conflicts of interest.
“I am concerned about the rapid growth of leveraged corporate lending and the lack of appropriate response from the Financial Stability Oversight Council (FSOC) and your individual agencies,” Warren wrote. “I fear that continued growth in leveraged lending – along with the steady degradation in loan terms – creates significant risk to the financial system and the American economy.” (Reporting by Kristen Haunss Editing by Jon Methven)