$1.6 trillion in risky ‘leveraged loans’ are overhanging the global economy

An
art installation titled “Hang On a Minute Lads, I’ve Got a Great
Idea” by British artist Richard Wilson — at The Peninsula hotel
in Hong Kong, in 2015 — is based on a scene from the movie “The
Italian Job”.
REUTERS/Bobby
Yip

• The total of corporate leveraged loans has hit $1.6
  trillion globally, far exceeding the records set prior to the
  crisis of 2008.
• The loans ballooned after the Trump Administration
  reversed a stricter Obama-era policy discouraging high
  leverage.
• Now, leverage is increasing, while underlying covenant
  quality is decreasing.
• The US Federal Reserve, the Bank of England and the
  Reserve Bank of Australia have all sounded the alarm over the
  loans. 

It is only October and already the UK economy has set a dubious
new record for the year: Leveraged loans to British
companies have hit about £40 billion ($52 billion), according to
the Bank of England. Prior to the financial crisis, new
issuances of such loans only totalled £30 billion ($39 billion).

Bank
of England

Britain’s stock of risky corporate debt is part of a trend.
Globally, leveraged loans have hit $1.6 trillion, according
to Institute of International Finance: 

IIF

Central banks are starting to worry that the corporate world may
have taken on too much debt, and that the stock of risky debt
overhanging the global economy might start to behave the way
sub-prime mortgages did prior to 2008.

The Bank of England recently suggested that leveraged loans might
become a bigger problem than sub-prime mortgages were: “The
Committee is concerned by the rapid growth of leveraged lending,
including to UK businesses,” the BOE’s Financial Policy Committee
said recently. “The global leveraged loan market is larger than –
and growing as quickly as – the US subprime mortgage market was
in 2006.”

The Reserve Bank of Australia has the same concerns.

The amount of “leverage” — the multiples in debt that companies
are getting into — is growing, too.

“If you look at leverage ratios, they are getting riskier because
they are getting higher. Obviously, as a company takes on more
debt it’s a riskier proposition than a company that takes on less
debt,” said Marina Lukatsky, a director at the Leveraged
Commentary & Data unit of S&P Global Market
Intelligence, in a conversation with Business Insider.

In 2013, the “issuance” of new leveraged loans peaked at $607
billion. But
regulators under President Obama frowned publically upon excess
leverage, and the market declined through 2015 to a low of
$423 billion. After President Trump took office, however,

his appointees told the banking sector that they were going to be
less strict about loan leverage. In 2017, new loan issuance
went back up, to $650 billion — a new record.

The total of new leveraged loan issued last year exceeded
pre-crisis levels by about $100 billion

Put simply,
leveraged loans are given to troubled companies who can’t get
access to cheaper credit via a normal loan from a bank or by
raising an investment-grade corporate bond. The “leverage” comes
from private equity (PE) groups, who invest their own money in
return for a chunk of equity in the company, in combination with
the loan. The rest of the funding may be provided by banks. 

The loans are then bundled and sold on private markets in the
form of collateral loan obligations — bundles of debt that can be
bought and sold like mortgages. The PE groups are hoping that the
equity and debt investments they make are enough to turn the
companies around. When that happens they can sell their stakes at
a premium.

Investors have poured money into leveraged loan products because
the companies who take them are required to pay higher rates of
interest than they would get by holding government bonds.

Most of the loans are being made in the US.

Business Insider asked the Leveraged Commentary & Data unit
of S&P Global Market Intelligence to pull its data on
leveraged loans so we could get a clear view of just how big a
market it has become. The numbers show the loans are becoming
bigger — and riskier — over time.

Here is the total volume of new leveraged loan issuance in US
dollars. Last year was a record, exceeding the pre-crisis level
by about $100 billion. And 2018 will be another strong year:

LCD, S&P Global Market
Intelligence

Transaction size — the total of debt and equity in leveraged loan
deals — is also approaching a new peak, although it remains below
the 2007 record:

LCD, S&P Global Market
Intelligence

Perhaps most worryingly, the debt-to-EBITDA ratio of the average
loan is once again heading toward a multiple of six, per LCD,
S&P Global Market Intelligence said.

The ratio measures the amount of debt taken on by a company in
comparison to its earnings before interest, taxes, depreciation
and amortization. The higher the multiple, the bigger the loan in
relation to the company’s ability to pay it off:

LCD, S&P Global Market
Intelligence

‘No, no, no, no, no’

The “6x” multiple is significant. In 2013, under the Obama
Administration, regulators frowned upon leveraged loans issued at
six times earnings. Between 2013 and 2016, leveraged loan volume
declined, and so did debt multiples. 

But Trump Administration officials have been more relaxed.
Issuance went up. This year, more leveraged loans were issued at
over 6x. 

Joseph Otting, the Comptroller of the Currency, told
a financial conference in Las Vegas in February that
banks could proceed beyond the old 6x level as long as they felt
it was sound. “When (the idea of the) guidance came out — it
was like people were afraid to jump over the line without feeling
the wrath of Khan from the regulators,”
Otting said .

“But you have the right to do what you want as long as it does
not impair safety and soundness. It’s not our position to
challenge that.”

Later, in May, he reiterated, “I
think it was always intended to be guidance,” rather than a
cast-iron rule

That statement was in stark contrast to the one made
by Federal Reserve official Todd Vermilyea in 2014, under
Obama. In a speech to bankers on whether he wanted to see
corporate loans go over six times earnings, Vermilyea said:
“No,
no, no, no, no.” 

The 6x line is still an important concept in judging whether a
company has taken on too much leverage, according to
S&P’s Lukatsky.

“The leveraged lending guidelines that were issued in 2013, they
stated that if a company has a leverage issue of six times or
higher, it basically raises concerns with the regulators,”
Lukatsky told Business Insider.

“Six times became a line, if you are above six times you are
considered riskier to the regulator.” 

“It’s kind of like you’re either above or below that line,”
she said. “Now  we’re at 5.8, so we’re almost there, so
it is notable.”

‘Highly leveraged deals account for a growing share of new
leveraged loan issuance and have surpassed pre-crisis highs’

The International Monetary Fund (IMF) is also worried that the
number of loans over 6x are going up as a percentage of the
whole.

“Notably, highly leveraged deals account for a growing share of
new leveraged loan issuance and have surpassed pre-crisis highs,”

the IMF said recently.

“Bank balance sheets have strengthened … but nonbank financial
entities have increased their leverage, including through the use
of derivatives. In the euro area, leverage in the corporate and
sovereign sectors remain elevated.”

This chart from the IMF shows the percentage of deals at or near
6X leverage rising over time:

IMF

A company’s creditworthiness is measured by its “interest
coverage ratio.” The ratio measures the amount of interest a
company must pay compared to its earnings. The closer a company
gets to coverage of just one — in which a company’s interest
payments are equivalent to 100% of its profits — the worse the
coverage ratio looks.

Companies’ ability to cover their interest payments is better now
than during the crisis, although it has recently declined,
according to LCD/S&P Global Market Intelligence. Since 2014,
the average interest coverage ratio has declined by 17%, from a
high of 3.37 to 2.79 this year:

LCD, S&P Global Market
Intelligence

As interest rates rise, companies’ ability to cover their debts
declines

The potential worry is that the recent decline is a sign of
emerging fragility among the companies paying those debts.

Credit ratings agencies — like Standard & Poor’s or Moody’s
or Fitch — may downgrade the quality of that debt or downgrade
the creditworthiness of the companies trying to pay it. The
crucial level is “BBB,” or “investment grade,” which signals a
minimum level of quality. Once companies, or their debt, fall
below BBB, they enter “junk” or “speculative” status. Many
investors have a policy to automatically sell debt with that
rating.

So as interest rates rise, and companies’ ability to cover their
debts declines, the chance of more leveraged loans falling below
BBB goes up — and that could set off a downward spiral of
automatic selling.

Interest on leveraged loans is typically based on a floating
rate, such as a “spread” above the London Interbank Offered Rate
(LIBOR). If LIBOR goes up, their interest burden goes up. Until
recently, interest has been low — both the BOE and the US Federal
Reserve have held interest rates near zero for years.

Spreads have been small, too. Those lowered costs have tempted
more companies into taking the loans, according to the IMF. 

“The share of lower-rated companies has increased because
compressed spreads have encouraged the buildup of leverage,”

its most recent global financial stability report said.

80% of leveraged loans are now ‘covenant-lite’

At the same time, the restrictions placed on companies taking the
loans have become more relaxed. Usually, when a company takes a
loan, it comes with a “covenant” that requires the company to
maintain certain financial standards, such as ensuring that its
earnings remain above a specific level in comparison to its debt.
But covenants have been largely abandoned in the leverage loan
market. Today, almost 80% of leveraged loans are “covenant-lite,”
according to the Bank of England.

That’s another sign of increasing risk, S&P’s Lukatsky told
Business Insider. “The share of deals that are lacking typical
covenant protection … is also increasing, so there is a
definite a level of risk here,” she said.

“Good or bad is kind of a relative term but as far as risk is
concerned, at least based on these metrics, definitely.”

Anton Pil, the head of JPMorgan’s $100 billion alternative
investment arm, gave a presentation in London earlier this month
that also worried about “covenant-lite” debt. “If you look
back in 2007, we were worried about cov-lite debt in 2007, and
that number was about a quarter of the market,”
Pil said.

“Today, it’s almost 80% … If you want to worry about something in
the next two or three years, this is it.”

‘Leveraged loans are typically sold to non-bank investors …
whose ability to sustain losses without materially impacting
financing conditions is uncertain’

The Bank of International Settlements — often referred to as the
central banks’ bank — put this $1.6 trillion debt pile in
context. The total of leveraged loans plus high-yield bonds
(both are types of high-risk junk debt) on the market has reached
$2.15 trillion, BIS says.

That is big enough to be a systemic threat to the stability of
the global finance system,
according to the most recent minutes from the US Federal Open
Market Committee. The Fed did not detail its concerns, saying
only: “Some participants [on the committee] commented about the
continued growth in leveraged loans, the loosening of terms and
standards on these loans, or the growth of this activity in the
nonbank sector as reasons to remain mindful of vulnerabilities
and possible risks to financial stability.”

So who gets hurt if the boom collapses?

The Fed did not say, and the Bank of England admits it is not
clear. But it won’t be the banks. The BoE said all UK banks were
now robust enough to withstand a 2008-level crisis. And, as the
Fed noted in its commentary, it believes the risk is located in
the “non-bank sector”.

That is because banks have long since sold on the loans to less
robust customers. The BOE doesn’t know if those investors are
strong enough to withstand their potential losses: “Leveraged
loans are typically sold to non-bank investors (including to
collateralised loan obligation funds), whose ability to sustain
losses without materially impacting financing conditions is
uncertain,”
it’s financial policy committee said in early October.

Bank of
International Settlements