Taking It All In: Understanding Leveraged Lending in the U.S. Economy

9 Apr 2019
Read Time 5 mins
Categories :
Banks and Asset Markets

Some have recently raised concerns about the risks posed by leveraged lending and the role played by large banks in this market.  In this post, we provide important context for understanding the leveraged lending market and we highlight recent research that sheds light on the important role that banks play in monitoring and assessing the health of these borrowers.  Overall, we show the risks of leveraged lending, though not immaterial, are not outsized relative to the U.S. economy.  We also show that claims asserting that lending standards have been weakened and that banks are derelict in their oversight of these borrowers is incorrect and fails to consider the totality of the leverage lending market.

Leveraged Lending Defined

Companies come in all shapes and sizes.  Some are large and some are small.  Some are old and some are young.  And from a risk perspective, some companies are riskier than others.  As a specific example, a well-established company with a proven track record is likely to be less risky than a startup that is trying to create a brand-new market.  Broadly speaking, a “leveraged loan” is a loan that is made to a riskier corporate borrower.  While no universal definition exists, a common working definition of a leveraged loan is a loan made to a borrower with a credit rating below investment grade.  For the many borrowers without a credit rating, a leveraged loan is often defined as a loan made to an unrated borrower that carries a high interest rate.

Sizing the Leveraged Loan Market

Due to the lack of a standard definition of leveraged lending, it is challenging to measure the size of this market with precision, though there are a number of good estimates.  The Loan Syndications and Trading Association (LSTA), for example, estimates the total amount of outstanding leveraged loans to be $1.5 trillion.  This is a sizable number by any definition, but this amount must be compared to the amount of other forms of debt and risk in the U.S. economy.

 

Source: Federal Reserve data, Financial Accounts of the United States – Z.1, available at https://www.federalreserve.gov/releases/Z1/current/default.htm, SIFMA US Mortgage Related Issuance and Outstanding, available at https://www.sifma.org/resources/research/us-mortgage-related-issuance-and-outstanding; SIFMA US ABS Issuance and Outstanding, available at https://www.sifma.org/resources/research/us-abs-issuance-and-outstanding/; The Loan Syndication and Trading Association data on Leveraged Lending, available at https://www.lsta.org/

 

In the left-hand panel of Table 1, we report the amount of total debt outstanding for various sectors of the U.S. economy.  As shown in the table, as of 2018, nonfinancial business debt, which includes both loans and bonds, totaled $15.2 trillion.  In addition, financial sector debt totaled $16.3 trillion, while household debt in the form of mortgage and consumer debt totaled $14.3 trillion.

The right-hand panel of Table 1 compares the total outstanding amount of bonds that are backed by various forms of debt.  Collateralized Loan Obligations, or CLOs, are a debt instrument that contain leveraged loans and are similar in concept to mortgage bonds that pool a large number of loans into a single security to provide diversification.  In 2018, there was $600 billion outstanding in CLOs.  The total amount of outstanding bonds backed by asset-backed debt (credit cards, autos, student loans, etc.) was $900 billion.  Finally, while these amounts are significant, they are far outweighed by mortgage-related securities, which totaled $8.4 trillion outstanding in the case of agency-backed mortgage securities, and $1.4 trillion in the case of non-agency or “private label” mortgage securities.

The data presented in Table 1 are useful for placing the size of the leveraged loan market in context.  When considered in the context of the entire U.S. economy, the size of the leveraged loan market is more modest than it appears when viewed in isolation.

It is also important to consider the performance of the leveraged loan asset class.  On the whole, and as detailed in the Federal Reserve’s Financial Stability Report, these loans have performed well and currently exhibit a low default rate of roughly two percent.  Of course, losses may well rise in the event of a downturn, but loss rates only rose to roughly 10 percent in the depths of the financial crisis, far less than loss rates on other asset classes such as subprime mortgages.  In addition, these loans are made broadly across the corporate sector and are not concentrated in any one specific industry or market segment, which provides important diversification benefits.  Accordingly, while one cannot rule out the possibility of losses in this sector, the historical performance of the asset class, its breadth across the corporate sector, and the breadth of the underlying investor base all serve to mitigate potential losses.

Leveraged Loan Underwriting and the Role Played by Large Banks

Some have argued that the underwriting standards applied to leveraged loans have deteriorated and increased the risk to the U.S. economy.  Specifically, commentators have pointed to a lack of loan covenants that empower the lender to periodically assess the creditworthiness of the borrower and demand payment or other remedies if a borrower’s credit quality worsens considerably.  The purported increase in the prevalence of such “covenant-lite” loans has been identified as a key risk factor in the leveraged lending market.

Recent research, however, shows that this characterization of the leveraged loan market is incorrect and misleading.  Specifically, leveraged loans are typically made in two parts.  The first part of a leveraged loan is a revolving credit facility that is held by one or more banks.  The second part of a leveraged loan is a term loan that is often sold to institutional investors such as a pension fund or insurance company.

Source: Berlin et al, Concentration of Control Rights in Leveraged Loan Syndicates, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2960757&download=yes

 

The researchers make the valid point that one cannot judge a leveraged loan by considering the term loan in isolation, but must consider both the term loan and the revolving credit facility.  The researchers show that the revolving credit facility held by a bank almost always contains a variety of covenants that are used by the bank to assess the borrower’s credit quality.  The term loans often do not contain covenants, but the holders of the term loan benefit from the credit oversight provided by the bank.  Specifically, requirements placed upon borrowers by banks that limit leverage or overall riskiness benefit both bank and non-bank lenders.  In this way, pension funds and insurance companies that do not regularly engage in credit analysis benefit from the expertise of banks.  The researchers show, as seen in Figure 2, that when both the revolving and term loans are considered together, less than 2 percent of leveraged loans are truly “covenant-lite” and this proportion has remained stable since 2005.  In the words of the researchers, “our evidence shows that nearly all leveraged loan borrowers remain subject to financial covenants and that banks have retained their traditional role as monitor of borrowing firms.”

Conclusion

Over the past several years, bank lending in the leveraged loan market has increased for a number of reasons.  While it is the case that these loans do present some risks, the size of this market is not outsized relative to other debt markets such as total debt issued by the nonfinancial business sector, or mortgage or consumer debt.  The recent characterization of leveraged loan standards as weak and banks as being derelict in their oversight is incorrect and does not consider the totality of the leveraged loan market.  Finally, it is important to recognize that economies grow by taking risks.  When combined as part of an overall credit and risk-management strategy, lending to riskier companies is a worthwhile pursuit that benefits the whole economy.

Forum Updates