Thirst versus prudence

Leveraged loans are in vogue. Banks, issuers and investors love them, pushing issuance close to record highs in 2014. Regulators, however, face a far more daunting challenge: succeeding in supporting a fast-growing industry while reining in its riskier tendencies.

How much is too much? When should financial service providers, seeking risk to fund reward, be reined in – and when do rules go too far, threatening the very lifeblood of the banking sector?

Financial regulators have battled this conundrum for years, always striving for a reasonable balance. Sometimes they fall short – witness the financial crisis, caused by excessive risk-taking and a deficit of smart regulation. The ensuing reaction – understandable if not always logical – was to tie lenders up in knots, suffocating them with rules in an attempt to prevent a repeat of 2008.

Just sometimes, though, regulators take a deep breath and clear their heads. They forget the torrid events of the recent past, and search for words that treat financial providers as responsible adults capable of weighing risk, shouldering responsibility, and harnessing their wilder and riskier (pre-crisis) tendencies.

That approach – prudent and watchful – is the one adopted by US regulators over leveraged loans. By any measure this is a market enjoying a golden era. Total US issuance hit a record high of US$1.25trn in 2013, according to Thomson Reuters data, with deal numbers nudging the 3,000 mark.

This year saw a strong first half, a drastic third-quarter wobble and then markets stabilising again by October. Volumes, said HSBC’s global head of leveraged and acquisition finance Richard Jackson, were “up there ahead of pre-crisis record levels”, following a “very good year for M&A financing, and for leveraged finance in general”.

Total issuance in the current year through to November 7 reached US$922bn, slightly down on last year’s record numbers but a 50% increase over the same period in 2012.

A steady flow of activity was interspersed by a few acquisition-led blowout deals. In April, US-Singaporean chip developer Avago Technologies secured US$5.1bn in financing to back its US$6.6bn acquisition of LSI Corporation. In September, Burger King raised US$7.25bn in financing to back its US$11bn purchase of Canadian coffee and doughnut chain Tim Hortons.

More of the same

Most analysts suggest that activity will remain strong heading into the new year. Bankers interviewed for this story point to “more of the same” going into 2015.

Christina Padgett, a senior vice-president in Moody’s US corporate finance team, tipped issuance to be underpinned by a strong US economy and low rates of corporate defaults.

“Moody’s expects the US leveraged loan market to stay attractive going into 2015 as rates are likely to stay low, and defaults are unlikely to rise,” she said. “There’s a lot of liquidity out there in the market, so when investors look at this space they are looking at pretty good credit conditions.”

But hang on

Some, though, worry that the US market has become a bit too frothy for its own good, and that riskier practices redolent of the pre-crisis era may again be creeping back into play.

On November 7, it became clear that those worriers included US regulators. That was the day that three federal agencies, the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of Comptroller of the Currency, noted in their annual Shared National Credits review that leveraged loans comprised US$254.7bn, or 74.7%, of total SNC “criticised” assets in 2014, up from US$227bn the previous year, despite accounting for barely a fifth of all regulated lending.

“Criticised” assets are defined in the SNC review as those rated on a broad scale stretching from “special mention” all the way down to “loss”.

This matters, and to both regulator and regulated. For US lenders, struggling for traction in a world dominated by rock-bottom interest rates and throttling rules, the market has become something of a panacea, offering both risk and reward.

“Leveraged loans provide respite to under-pressure banks by generating returns as well as underwriting fees,” said Heath Tarbert, a partner in Allen & Overy’s US bank regulatory group.

Yet some worry that banks have – again – gone too far, and are failing to temper their predisposition for risk. Regulators warn of finding weak underwriting standards on deals and shaky risk management practices.

Bankers deny the charges but the accusations are beginning to stick. Moody’s Padgett points to a clear “deterioration in credit quality consistent with a market” saturated with buyside demand, and deals offering increasingly aggressive terms and conditions.

Federal agencies have, so far, opted for a softly-softly approach to regulating this vibrant corner of the market. In March 2013, the Fed and the OCC introduced guidelines, rather than hard-and-fast rules, that counselled banks not to underwrite loans with debt-to-earnings ratios of more than six times. Exceed that number, came the attendant warning, and your bank will face tougher oversight, including tougher assessments of loan-loss rates in future stress tests.

Yet banks have opted, all too regularly, to view those guidelines as gates rather than barriers. This year’s SNC review noted that 15% of all loan transactions completed in the 15 months from June 2013 were leveraged by at least eight times debt to earnings.

The review also identified a welter of key weaknesses at banks engaged in leveraged lending, including poor credit analysis, a lack of justification for asset valuations, and a tendency to rely on financial projections provided solely and wholly by the issuer.

Last year’s guidelines, moreover, demanded that borrowers should demonstrate an ability to repay 50% of the value of the loan within seven years. In November 2014, 77% of borrowers were projected to hit that target, down six percentage points from the previous year.

In a joint statement issued on November 7, the trio of agencies led by the Fed warned that banks should not “heighten risk by originating and distributing poorly underwritten and low quality loans”. Any institution “unwilling or unable to implement strong risk management processes” should down tools “until their processes improve sufficiently”.

In November, lenders were told that in order to extend fresh credit to a borrower previously criticised by regulators, they would have to meet the same exacting standards of a new loan.

Blurred guidelines

Banks, for their part, have pushed back, complaining that guidelines are either too vague or that agencies have offered conflicting advice. Most market players describe it as an arbitrary and blunt tool being used to shape and form a nuanced and thriving market.

To Tarbert, the guidelines’ definition of a leveraged loan appeared consciously blurred. “Reading through the guidance, even as a lawyer it is a challenge to figure out exactly what is and what isn’t defined as “leveraged”, he said.

Then there is the fear that tighter guidelines will lead to a fall-off in issuance, particularly among fast-growing firms with the greatest need for working capital.

Dan Whalen, head of loan syndications, Americas at BNP Paribas, said the guidelines issued by the Fed were “increasingly having an impact”, and were proving “damaging to smaller, lower rated businesses’ ability to access the US capital markets”.

Taking air out of the tyres

Some have sympathy for regulators, who find themselves in a tricky spot. On the one hand, they do not want to further undermine US lenders, already pressed beneath a mountain of new rules. Regulators also see the danger inherent in disintermediating domestic banks out of such a profitable market.

A slew of non-bank and foreign service providers have all dipped their toes into the US leverage loan market this year, including Jefferies, Macquarie Capital, and Nomura, and more are expected to come.

On the other hand, they want and need to cover their backs in case the economy and the market go sour. The question, as ever, is where to draw the line. Even bankers admit to the need to temper some of the excesses of leveraged finance.

“There is a need to take some of the air out of the tyres,” said a leading US banker. “But the key will be to do it carefully. We all want to see this market continue to succeed.”

So far at least, that wish is being fulfilled. Issuance is likely to remain strong, said Moody’s Padgett, with the deal pipeline, based on M&A financing and leveraged buyouts, looking “pretty good” going into the first quarter of 2015.

And so far, regulators, in an admirable attempt to allow a fast-growing market to find its own equilibrium, have opted to wag fingers and criticise and cajole from the sidelines, rather than temper and meddle.

Will banks in turn prove willing and able to react like responsible adults, and rein in their more reckless tendencies in the leveraged loan space? Only time will tell.