‘Dumb Things’
“There is a case to be made that if a bank knows what it is doing, understands the risks, and is holding appropriate capital, they should be able to take the risks they want to take,” said Tim Clark, a former senior supervisor at the Federal Reserve who helped manage the central bank’s stress testing of the largest banks after the 2008 financial crisis.
“But as we learned during the crisis, it’s hard to overstate the capacity of banks to do dumb things, especially when there is a lot of money to be made from trying to keep the party going,” he added.
Vermilyea’s remarks indicate the Fed isn’t as comfortable as Otting with the state of the market. The Fed official cited three particular areas of concern:
- A proliferation of loans with weak covenants, which are meant to protect creditors if borrowers run into trouble.
- Terms known as incremental facilities that layer additional debt onto an existing loan.
- Loan adjustments known as “add-backs” that make borrowers’ profits appear better, which could overstate their ability to repay loans.
So-called covenant-lite loans, which were once rare, now make up about 80 percent of the market. Incremental facilities are being added to loans at a record pace this year. Companies are making ever-rosier earnings assumptions, which allow them to heap on more debt. About 38 percent of the earnings figures used to calculate leverage in acquisition-linked loans this year were made of add-backs, according to research firm Covenant Review. That’s up from 10 percent in the first quarter of 2015.
Despite Vermilyea’s warnings, there may not be a hammer behind it. Agency heads appointed by Trump, including Fed Chairman Jerome Powell, have said they won’t use their 2013 guidance to justify punishments against banks.
The regulatory environment can be likened to having a speed limit “but no police enforcing it,” said Anat Admati, finance and economics professor at Stanford University Graduate School of Business.
This article was provided by Bloomberg News.