The steady drumbeat of warnings over the surge in risky corporate borrowing is growing louder and louder. Time and again, regulators in the U.S. and Europe have pointed to the hazards of businesses taking on too much debt.
At issue is the $1.3 trillion leveraged lending market, composed of high-yield loans from firms with some of the weakest finances. While Federal Reserve and European Central Bank officials have drawn attention to these heavily indebted companies and the deteriorating standards of loans bundled into securities called CLOs, most regulators are careful to say a repeat of 2008 is unlikely because investors, rather than the banks they oversee, hold most of the debt.
Yet that’s created a new, and potentially more dangerous, kind of risk. Precisely because roughly 85% of leveraged loans are held by non-banks, regulators are largely in the dark when it comes to pinpointing where the risks lie and how they’ll ripple through the financial system when the economy turns. More and more, critics are questioning whether regulators like the Fed have a handle on the problem or the right tools to contain the fallout. A big worry is highly leveraged businesses employing thousands could face severe financial stress and, in some cases, insolvency, deepening the next downturn.
“I always remind myself that even the smartest policy maker with the most far-reaching perspective, data and tools was basically blind-sided by the breadth and depth of the housing crisis,” said Mark Spindel, chief investment officer at Potomac River Capital. “Leveraged loans and corporate debt are not housing, but maybe it’s more pervasive than we think. We can’t take any of the CLO, leveraged loan, or private debt growth for granted.”
CLO Demand
Signs of excessive risk-taking have emerged in any number of markets. But leveraged lending has raised eyebrows partly because of how lightly it’s regulated. Fueled in large part by demand from collateralized loan obligations that offer interest rates that approach 9% on some riskier portions of the debt, the market for leveraged loans has more than doubled since 2012.
One of the ironies of the boom is that much of the risk-taking decried by central banks and regulators is largely of their own making.
Years of ultra-low rates have made it easier than ever for less-creditworthy companies to borrow large sums of money, all while pushing investors toward riskier investments. At the same time, post-crisis bank regulations have fueled the rise of shadow lenders, which helped facilitate the growth of leveraged lending. Then, financial watchdogs appointed by the Trump administration started encouraging Wall Street to dial-up more risk last year by easing guidelines to limit lending to deeply indebted companies, which freed banks to compete more directly with non-bank firms to underwrite the riskiest loans.
Adult Supervision
And now, with U.S. interest-rate cuts back on the table, the Fed may end up fueling even more of the high-risk lending that they’ve tried to rein in. A Fed representative declined to comment.