According to recent data from Moody’s investor services, corporate leverage in the U.S. has reached pre-2008 levels, meaning banks are facing risk that is elevated above what has been seen since the financial crisis. The good news, according to Moody’s, is that at this point, their credit analysis of the banking segment indicates that those risks are “contained” over the next 12-18 months.
But, the report notes, that containment is predicated on the idea that conditions in the U.S. economy will remain largely unchanged during that time period.
“If operating conditions in the U.S. were to materially worsen, the risk from these exposures would rise appreciably and indirect risks could begin to have greater bearing on banks’ creditworthiness, especially if mitigating actions prove difficult to implement,” the report said.
All in, the leveraged loan market in the U.S. has risen to over $2 trillion. That growth, as Moody’s noted, reflects both a more favorable market for borrowers in terms of offerings, as well as an “increasing credit risk appetite of non-banks and low interest rates due to tighter credit spreads, which have contributed to increasing competition leading to weaker covenants and looser capital structures.”
Banks, according to Moody’s, own a “modest amount” of total U.S. leveraged loans outstanding, and the loans themselves are a small portion of their total commercial and industrial loan exposures.
“U.S. banks’ direct leveraged lending risk is contained and mitigated,” noted the report. “Banks’ healthy earnings and strong capital buffers should be adequate to absorb the risks from leveraged loans on their books and holdings of collateralized loan obligations.”
Indirect risks, according to Moody’s, are more difficult to predict, measure or mitigate. Among the things that could cause trouble for increasingly leveraged firms – and the banks that hold the notes – increasing interest rates, tighter liquidity in the market and, of course, the possibility of an economic downturn are all considered strong contenders in the indirect risk field. The main concern comes on behalf of borrowers and how well they can manage refinancing risk.
Moody’s is also concerned about the possibility of reduced leveraged loan valuations pushing market and credit losses in the future. Downturn in the leverage loan market, they noted, “could have spillover effects to bank lending in other sectors that are cyclical or particularly sensitive to changes in investor confidence, such as commercial real estate, energy and commodities.”