Federal Reserve survey warns leveraged loan standards are falling

Federal
Reserve Board Chair Jerome Powell testifies during a House
Committee on Financial Services hearing, Wednesday, July 18,
2018, Capitol Hill in Washington.
Jacquelyn Martin/AP

• An obscure and often overlooked Fed survey is flashing a
  warning about the growing leveraged loan market.
• The Federal Reserve’s Senior Loan Officer Opinion Survey,
  which takes responses from 70 domestic US banks, showed that
  lending standards for commercial and industrial (C&I)
  loans eased in the third quarter.
• Demand for commercial and industrial loans also fell,
  the survey said.
• Several major institutions, including the Fed itself, and the
  Bank of England, have warned about the rise of leveraged loans.

This year’s rumbling debt story looks like it isn’t going
anywhere — despite numerous warnings from major figures in the
world of finance — especially if banks continue to lend without
adequate protections in the booming leveraged loan market. 

According to the Federal Reserve’s Senior Loan Officer Opinion
Survey, which takes responses from 70 domestic US banks,
lending standards and terms for commercial and
industrial (C&I) loans eased in the third quarter of this
year. 

The figures apply to both large and mid-market companies
suggesting that so-called “covenant lite” lending is permeating
much of the US credit market.

Covenant-lite loans often lack lender protections that are
built into traditional loan contracts, potentially allowing
companies to take on more debt or loosen restrictions on dividend
payments.

Global leveraged loan volumes, which have increasingly
featured less stringent covenants, recently hit a total volume of
$1.6 trillion, according to the Institute of International
Finance.

Banks surveyed by the Fed also cited increased
competition from other lenders as an important reason for banks’
easing their standards or terms. Increased tolerance for risk is
also thought to be behind banks’ decision to reduce covenant
quality on loans. The Federal Reserve, the Bank of England, and
the Reserve Bank of Australia
have all previously sounded the alarm on the decreasing quality
of leveraged lending. 

The data also suggests that loan demand is falling citing
increases in customers internally generated funds, reduced
investment, and customers shifting their borrowing to new lenders
as reasons for the slowdown. 

According to the Fed’s survey: “[Banks are] reportedly
narrowing loan rate spreads on C&I loans to firms of all
sizes. A significant net fraction of banks also reportedly eased
loan covenants to large and middle-market firms.”

The picture is different for foreign banks, however, which
reported that demand for C&I loans remained unchanged over
the third quarter.

While reduced covenant quality is often associated with
higher credit supply within debt markets putting borrowers in a
position of strength. However, highly leveraged corporates who
are able to continue piling on debt are at the centre of a
worrying trend in the world of credit which looks set to
continue.