Score One For The Feds On Risky Loans

The Fed has been vigilant about risky loans – among the more visible hallmarks of the financial crisis that almost brought the global banking system to its knees – so much so that they have been falling out of favor.

The Wall Street Journal reported Thursday that leveraged loans, which typically have been doled out to companies carrying heavy debt loads, and thus at risk should the burden of carrying the loan not be supported by operations, fell by as much as 20 percent in 2015, through the period that ended in October, from the previous year. 

That comes in tandem with underwriting standards that have been toughened up, with the impact of tightening the lending spigot. 

As the Journal noted, the debate over leveraged finance, and the Fed’s purview over that arena, has raged across the years as regulators have looked to paint rules across broad swathes of the financial industry rather than target individual lenders. The banks themselves have argued that they serve primarily as conduits for the loans, carving them up and selling them to investors.  But then again, they do not have as much skin in the game as they would have had they been, and were they now, the ones holding the loans. Given the servicing nature of the banks in this type of transaction, the business is a lucrative one.

The regulatory scrutiny of leverage loans has been such that the Fed, the FDIC, and the Office of the Comptroller of the Currency have all joined in to, as the Journal put it, “strong arm” banks across the United States to demand that the lenders work to comply with at least the minimum underwriting standards, regardless of where risk is concentrated. That scrutiny extends to monthly reviews of leveraged loans across banks, and private letters, a financial instrument, are grabbing even more attention. In short, the emphasis is on transparency.  Key among industries that raise some concerns among regulators in the leveraged space are energy firms that may have been hit hard, operationally, by the vagaries of energy prices.    

Some lenders have already been feeling the heat, as the U.S. based units of financial heavyweights such as Credit Suisse and Deutsche Bank AG received letters last year citing the need for “immediate attention” on their leverage loan carryings, the Journal noted, citing unnamed sources.

One consequence of the heightened oversight is that companies have been going to firms that are not in fact beholden to the regulatory agencies and the Fed, including firms such as Jefferies Group – and firms in that (less regulated) class have arranged about 8 percent of all leverage loans in volume, as of the second quarter of this year, a heady jump from the 3.8 percent seen last year.

Thus far the chilling effect is palpable on the industry overall, with total leverage loan volume at $382 billion, down 21 percent from the same period through October of last year, and quite a bit lower than the peak tally of more than $600 billion seen as recently as 2013 (though of course the year is not over yet for 2015). Leverage buyouts are down too, off 11 percent through the same timeframe.