NEW YORK, Oct 24 (LPC) - Regulators are concerned about a material loosening of terms and weaknesses in the risk management of the US$1.1trn US leveraged loan market, a Federal Reserve official said at an industry conference Wednesday
Covenant-lite loans, incremental facilities and so-called addbacks to earnings before interest, tax, depreciation and amoritization (Ebitda) are three areas regulators are focusing their attention, according to prepared remarks from Todd Vermilyea, senior associate director at the Federal Reserve, who was speaking at the Loan Syndications and Trading Association’s 23rd annual conference in New York. The event is closed to the press.
“The presence of these practices, especially without the appropriate controls, may lead to safety and soundness concerns,” he said.
The leveraged loan market, which finances companies including American Airlines and retailer Party City, has recently been flooded with aggressive deals featuring high debt levels and loose terms.
More than US$585bn of US institutional loans were arranged in the first three quarters of the year after a record US$923.8bn was issued in all of 2017, according to LPC data. In 2007, at the height of the pre-crisis buyout market, US$425.8bn of institutional loans were arranged.
Leverage for buyouts increased to 6.94 times in the third quarter, the highest level since the same three-month period in 2014, according to the data. About 73% of the leveraged institutional market in the first nine months of 2018 was covenant-lite, loans that lack a full package of lender protections.
Covenant-lite loans, and how they will perform in a downturn, is not well understood, he said, because there is no data available. Incremental facilities, which allow for additional borrowing and have grown in popularity, can provide an economic benefit to borrowers, but rarely have a limit on their use of proceeds and are typically utilized for non-earnings purposes.
He also highlighted Ebitda addbacks, which add back expenses and cost savings to earnings, which could inflate the projected capacity of borrowers to repay their loans, he said. He noted that supervisors have also seen transactions where borrowers can transfer secured collateral beyond the reach of senior creditor banks, a practice known as collateral stripping.
“The risks posed by these various contractual provisions could be mitigated with the appropriate risk management controls,” he said. “Some of these provisions could even be beneficial to the borrower – and are, presumably, benefits borrowers are willing to pay for – representing opportunities for originating firms.”
Supervisors, including through the Shared National Credit (SNC) program, will continue to assess bank practices on credit underwriting and loan documentation, he said.
“Supervisors will aim to ensure that underwriting standards are aligned with risk appetite and that risk management practices are keeping pace with changing market dynamics for loans.”
Federal Reserve policymakers have previously expressed concerns about loosening standards in the market.
“Some participants 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,” policymakers said according to minutes from their September meeting.
Regulators including the Fed and the Office of the Comptroller of the Currency updated leveraged lending guidance in 2013, describing loans without full lender protections as “aggressive,” noting that leverage of more than 6.0 times “raises concerns” and stating that companies should be able to pay back at least 50% of total debt within five to seven years. (Reporting by Kristen Haunss Editing by Michelle Sierra and Jon Methven)