Bank of England warns over growth of leveraged loans

Getty Images / Scott
Barbour

• The Bank of England is sounding the alarm over an
  underexposed area of the corporate debt market.
• It bears striking similarities to what happened in the
  US subprime mortgage market in the run up to the financial
  crisis, the central bank said on Thursday.
• The amount of leveraged loans to nonfinancial companies
  has risen to about $1.4 trillion globally.

The Bank of England on Wednesday raised the alarm about the
growth of so-called leveraged loans in the UK, saying that the
sector’s rapid growth should be a cause for concern for
policymakers and market participants going forward.

In the bank’s record of the October meeting of its Financial
Policy Committee — the body tasked with ensuring financial
stability in the UK — the BoE mentioned leveraged lending almost
20 times, variously calling it “concerning” and likening it to
what happened in the USA with sub prime mortgages in
the run up to the financial crisis.

At their most basic level, leveraged loans are loans extended to
people and companies with either pre-existing high levels of
debt, or a poor credit rating. These loans, therefore tend to
have higher interest rates meaning that rewards for lenders are
higher, while the risk of default is also higher due to the
nature of the customers.

Leveraged lending to corporates has ballooned in recent years,
with the global market reaching a value of around $1.4 trillion,
according to recent estimates. In the UK alone, £68 billion ($90
billion) of these loans have been issued in the last two years,
the Bank of England said on Thursday. This represents around 20%
of total UK corporate debt, when also including high yield bonds.

That rapid growth, along with falling standards of underwriting
for the loans — effectively giving loans to companies with even
more debt, or an even lower credit ratings — means
that there are now clear parallels between what is happening
in the space, and what happened with US housing in 2006 and 2007,
the bank said.

“The global leveraged loan market was larger than – and was
growing as quickly as – the US subprime mortgage market had been
in 2006,” the FPC report noted.

“As with subprime mortgages, underwriting standards had weakened,
there was significant uncertainty around the ultimate investors
in collateralized loan obligation securitizations and hence their
capacity to absorb losses, and borrowers would face higher
financing costs if interest rates or credit spreads increased,”
it added. 

The Bank of England’s warning comes less than two months after

ratings agency Moody’s issued a virtually identical warning,
saying that the market bears “eerie
similarities” to what happened with sub prime mortgages in
the run up to the crisis.

“The most serious developing threat to the current cycle is
lending to highly leveraged nonfinancial businesses,” Mark
Zandi, the chief economist at the analytics arm of Moody’s said
in August.

While it sounded the alarm on the corporate leveraged debt
market, the Bank of England struck a reasonably sanguine note,
pointing to “important differences” between leveraged loans and
what happened in the subprime mortgage market.

“A substantial proportion of subprime mortgages had been financed
by relying on short-term wholesale funding, including from money
market funds, and there had been an active repo market in
subprime mortgage securitizations. Banks had substantial
contingent liabilities related to subprime mortgages,” it said.

“This was not the case for leveraged loans.”