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House Financial Services Committee Hearing on the Emerging Risks of Leveraged Lending

House Financial Services Subcommittee on Consumer Protection and Financial Institutions

“Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending”

Tuesday, June 4, 2019

Key Topics & Takeaways

  • Systemic Risks and Oversight: Nini said that post-2008 crisis, virtually no new CLOs were created, and borrowing has slowed. This has dampened the institutional part of the leveraged loan market and firms are having trouble re-financing existing leveraged loans. Nini said when compared to firms without institutional leveraged loans, there are no adverse consequences in terms of investment, stock prices, or credit. He said as risks and defaults are relatively small and unproblematic, leveraged loans are one of the safest investments in capital markets. Vasisht stated the importance of fully understanding and appreciating the roles of banks in the market, as they underwrite loans, sell them to CLOs, then invest and hedge their risks.
  • Capital Buffers to Address Leveraged Lending Risk: Nini said in an economic downturn there would be losses but not systemic risks. He said that most leveraged loans are arranged by commercial banks, which are under continued regulatory surveillance, making it very unlikely for leveraged loans to escape oversight at origination. Further, Nini said he is not sure whether labeling the market systemic might be a trigger and that regulators are thinking carefully whether leveraged loans might warrant counter cyclical capital buffer, independently of how they’re labeled. In his opinion, counter cyclical capital requirements are a fairly “blunt” tool to address the modest risk of leveraged lending.
  • CLO Performance: Nini said the leveraged loan market spans across many varying industries and locations, providing much CLO investment in a broad set of loans and set of rules for a diverse portfolio. Nini said CLOs can be stabilizers in a downturn, as they have low default rates and are a small portion of the overall loan market. Gerding said long term excessive reliance on debt, particularly by financial institutions, is destabilizing. Ivashina said fundamentals are more observable in the CLO market, but understanding the legalities of each loan agreement, such as basket carve outs, leads to forms of erosion for agreements.

Witnesses

  • Erik F. Gerding, Professor of Law & Wolf-Nichol Fellow, University of Colorado Law School
  • Victoria Ivashina, Lovett-Learned Chaired Professor of Finance, Harvard Business School
  • Guarav Vasisht, Senior VP and Director, Financial Regulation Initiative, The Volcker Alliance
  • Gregory Nini, Assistant Professor of Finance, LeBow College of Business, Drexel University

Opening Statements

Chairman Gregory Meeks (D-N.Y.)

In his opening statement, Meeks said the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) are central in monitoring, quantifying and mapping out emerging systemic risks and designating systemically risky institutions. He expressed concern over the rapid rise of leveraged and coverage loans, and the Federal Reserve (Fed), International Monetary Fund (IMF) and other regulators calling these loans recession amplifiers. Meeks stated that the creation of the FSOC was one of the more important reforms in Dodd-Frank because the FSOC monitors system wide risk and has the capacity to designate non-bank financial institutions as systemically risky, adding that the OFR’s ability to monitor, quantify and map risks is important in informing the FSOC. Meeks said it is important to discuss the risks of leveraged lending and whether the current regulatory framework needs to be updated to prevent risks to the financial system.

Ranking Member Blaine Luetkemeyer (R-MO.)

In his opening statement, Luetkemeyer said the focus should be on whether leveraged lending poses systemic risks and that the potential concerns about leveraged lending should be assessed by the data.  Luetkemeyer stated the total amount of leveraged loans is estimated to be between one to one and half trillion dollars, comparing that to the total outstanding business credit of $15.2 trillion. Luetkemeyer said leveraged loans encompass a small portion of the overall loan and fixed income markets and have less systemic significance when considering banks’ capital requirements. Luetkemeyer said the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) are continuing to be attentive and are monitoring the risks associated with leveraged lending. He said he supports regulators’ commitment to the oversight and supervision of banks to protect against all loan risks.

Rep. David Scott (D-Ga.)

In his opening statement, Scott expressed his concerns about the size of the leveraged loan market and the quality of loans, particularly about the increase in covenant-lite loans and of nonbank entities. Scott also expressed concern about the challenge of highly indebted corporations in a slowing economy. He said the conversation boils down to the discussion of who holds risk and who can withstand the risk.

Testimony

Erik F. Gerding, Professor of Law & Wolf-Nichol Fellow, University of Colorado Law School

In his testimony, Gerding stated that the promotion of financial stability is important in efforts to end the cycle of debt and decrease excess borrowing, including by corporations in the leveraged lending market. He said a huge portion of leveraged loans are securitized or used to create complex financial products such as collateralized loan obligations (CLOs) which are backed by corporate debt, the cousins of collateralized debt obligations (CDOs) which were central to the 2008 crisis. He said there are two troubling similarities: 1) the underwriting standing in leveraged loans appear to be deteriorating, as covenant-lite loans are becoming prevalent, similar to the mortgage market years ago; and 2) that many CLO trades are through opaque markets or do not appear to be traded at all, with little research on who is buying these securities, for what purpose, and whether investors worry about market disruptions. Gerding said the increase in shadow banking and a lack of transparent market pricing means investors and regulators cannot rely on market pricing to police risks adequately, and that regulators must work harder to police threats to financial risk and stability.

Victoria Ivashina, Lovett-Learned Chaired Professor of Finance, Harvard Business School

In her testimony, Ivashina focused on whether the leveraged loan market could be a source of systemic risk, potential signs of accumulation of hidden risk, whether that risk could be amplified through the entities investing in this market, and how quickly it could affect the broader economy. She said there are signs of continuous buildup of risk through the erosion of creditors’ rights and elevated levels of leveraged. Ivashina referenced two parallels to the Global Financial Crisis in 2008: 1) lack of visibility into the quality of collateral backing of securitized products, which was at the heart of the loss of market confidence and the 2007 shut down of securitization across all asset classes; and 2) the central role of securitization, which she stated is paramount to the existence of the leveraged loan market with half of outstanding leveraged loans held by CLOs. Ivashina said banks’ holding of leveraged loans are substantially lower than they had been historically, decreasing from 25 percent in 2005 and 15 percent in 2007, to 8 percent today. Ivashina stressed the importance of knowing and monitoring the U.S. banking system exposure to potential risk in the leveraged loan market and sufficient capitalization to withstand negative shocks.

Guarav Vasisht, Senior VP and Director, Financial Regulation Initiative, The Volcker Alliance

In his testimony, Vasisht said that as overall U.S. business debt has “skyrocketed,” the size of the leveraged lending market has grown to a total of nearly $1.2 trillion, roughly equivalent to the size of the subprime mortgage market at its peak. He stated underwriting standards have deteriorated for leveraged lending, which led to nearly 80 percent of new covenant-lite issuances. Vasisht said that with most lending concentrated in the riskiest borrowers, amplified losses and default rates could increase in an “inevitable” economic downturn. He said that “fortunately,” large banks have more capital and liquidity post-2008, but regulators are weakening capital requirements, stress testing standards and undermining guidance. His made recommendations for OFR to be able to fill any data gaps and produce a comprehensive analysis on the risks of the leveraged lending market and for the OFR’s budget be restored and be determined outside the congressional appropriations process. Vasishst also recommended to reinstate the substance of their 2013 leveraged lending guidance, and regulators refraining from further weakening capital requirements and diluting stress tests and the withdrawal of the FSOC’s proposed interpretive guidance in order to mitigate risks in the nonbank sector and tightening supervisory standards.

Gregory Nini, Assistant Professor of Finance, LeBow College of Business, Drexel University

In his testimony, Nini said the leveraged loan market refers to the segment of corporate loans comprised of borrowers with relatively high amounts of debt, which increases the likelihood of default and raises the interest rate that a borrower pays. However, he said borrowers in the leveraged loan market are some of the largest firms in the U.S. and actual default rates have historically been quite low. Nini said the leveraged loan market has grown quite rapidly in recent years, putting it on par with the high-yield bond market, adding that there has also been strong growth in total credit to the nonfinancial business sector resulting in the appearance of elevated corporate credit risk. Nini said economists have made progress in understanding the sources of such risks and regulators must develop tools to identify, monitor and mitigate emerging threats to financial stability and the growth in corporate debt, beyond the leveraged loan market. Nini mentioned the growth of covenant-lite loans, saying this is a potential sign of a significant deterioration in underwriting standards. Nini said that the CLO market could experience a rapid slowdown in new issuance, limiting firms’ ability to issue new leveraged loans to institutional investors. He said the leveraged loan market does not seem to generate unique sources of systemic risk, that CLOs have stable sources of funding, and leveraged loan borrowers have widespread access to capital markets. Nini stated the existing regulatory regime seems well suited to monitor and mitigate risks arising from the leveraged loan market.

Question & Answer

Nonbanks

Reps. Barry Loudermilk (R-Ga.), Bill Foster (D-Ill), and Scott asked about regulating nonbank risks. Ivashina said there is not enough information about shadow banking, where equities outside of banks are, and what portion of these tranches are outside of the U.S. Vasisht said there is not sufficient information at this stage to fully understand nonbanks, and it would be good to understand the exposures and vulnerabilities to their funding structures. He also said it would be helpful for nonbank stress testing, but one of the problems in stress testing is the second order of effects. Nini said large nonbank institutions in the leveraged loan market are CLOs and mutual funds, each of which would have some form of regulatory coverage by the Securities and Exchange Commission (SEC).

Systemic Risks and Oversight

Reps. Al Lawson (D-Fla.), Roger Williams (R-Texas), Meeks and Luetkemeyer asked about potential risks and regulatory oversight of the market. Nini said borrowers in the leveraged loan market are among the largest in the U.S., many of whom are trading publicly, have bond market access, and have a line of credit with a bank. He said post-2008 crisis, virtually no new CLOs were created, borrowing has slowed, and this has dampened the institutional part of the leveraged loan market and firms are having trouble re-financing existing leveraged loans. Nini said when compared to firms without institutional leveraged loans, there are no adverse consequences in terms of investment, stock prices, or credit. He said as risks and defaults are relatively small and unproblematic, leveraged loans are one of the safest investments in capital markets. Vasisht stated the importance of fully understanding and appreciating the roles of banks in the market as they underwrite loans, sell them to CLOs, then invest, and hedge their risks.

Capital Buffers to Address Leveraged Lending Risk

Rep. Scott Tipton (R-Colo.) asked about counter cyclical capital buffer requirements. Nini said corporate defaults increase during economic downturns, and investors have suffered losses in the last two downturns, which he expects to occur again in the future. He said CLOs are not a source of systemic risk, as well as mutual funds, and banks and other investors, which hold some of the risks and are monitored by regulators. Overall, Nini said in an economic downturn there would be losses but not systemic risks. He said that most leveraged loans are arranged by commercial banks, which are under continued regulatory surveillance, making it very unlikely for leveraged loans to escape oversight at origination. Further, Nini said he is not sure whether labeling the market systemic would be a trigger, and that regulators are thinking carefully whether leveraged loans might warrant counter cyclical capital buffer, independently of how they’re labeled. In his opinion, counter cyclical capital requirements are a fairly “blunt” tool to address the modest risk of leveraged lending, which would affect all the products of lending, adding that the costs would be widespread.

OFR and Data

Reps. Foster, Meeks and Luetkemeyer asked about OFR functions and adequate access to data. Vasisht stated you cannot regulate something you do not fully understand, citing the lack of data available in the market. He said the issue can be resolved by granting the OFR funding so they can exercise their powers under Dodd Frank. Ivashina said the window for the leveraged loan market is can be found through banks, which do not hold many of the CLO tranches. She said most institutions holding CLO tranches are those in shadow banking, which prevents regulators from collecting data, especially as private data sets largely do not exist. Gerding said the OFR director should have power over the agency’s funding to be able to set a minimum funding level and ensure funding does not go below that level. Gerding said this is critical because OFR is at risk for reduced funding or staff losses.

CLO Performance

Reps. Andy Barr (R-Ky.) and Loudermilk asked about the performance of CLOs. Nini said the leveraged loan market spans across many varying industries and locations, providing much CLO investment in a broad set of loans and set of rules for a diverse portfolio. He said in CLO markets, due to maturities, rarely will the outstanding debt have to be paid. Nini said CLO’s can be stabilizers in a downturn, as they have low default rates and are a small portion of the overall loan market. Gerding said long term excessive reliance on debt, by financial institutions particularly, is destabilizing. Ivashina said fundamentals are more observable in the CLO market, but understanding the legalities of each loan agreement, such as basket carve outs, leads to forms of erosion for agreements.

Sub-Prime Lending

Rep. Al Lawson (D-Fla.) and Alexandria Ocasio-Cortez (D-N.Y.) asked about leveraged loan market comparisons to sub-prime lending in 2007. Gerding said the leveraged lending market is different than the mortgage lending market, as the leveraged lending market may be less systemically important. However, he said a shock to the market could affect the leveraged loan market in ways it did not affect the market during 2008, which as the leveraged loan market may not be regulated under Dodd-Frank. Vasisht said differences might make it easier to deal with leveraged loans over mortgage-backed securities but they still need to be addressed. He said it is important to discuss what information is missing about the market, to analyze data to make statements such as how exposed banks are to CLO market, what happens to nonbanks who invest in CLOs that have stress and the overall impact on the banking sector.

Securitization

Williams asked about the difference between corporate loan scrutinization and securitization of loan profiles. Ivashina said the comparison must be done carefully, though they are comparable in two areas: 1) potential lack of visibility; and 2) securitization, as the equity piece is one of the key elements in assuring the system is functioning. The mortgage backed loans had a lack of visibility into what securitized the mortgage obligations, due to corrupt organization practices. She said what happens in the loan market is different, as there are dealings with public companies, sophisticated institutions, and secondary markets. However, Ivashina said what underpins risk is through credit agreements, which is where the contractual weakness occurs. She said the complexity of an agreement goes beyond the contract’s life.

Covenant-Lite Loans

Williams asked about the main cause of covenant-lite loan increases and about adequate regulation. Nini said the emergence of covenant-lite loans reflects the convergence of high yield bond markets, which can be considered a covenant-lite product. He said high yield bonds do not have financial convenience like bank loans, and that a similar phenomenon is happening with leveraged term loans being sold to the same investors in the high yield bond market. Nini said that regulators seem to be very on top of monitoring this market.

For more information about this hearing, click here.