LEVERAGED LOANS | Again a Threat

Nov. 5, 2014–Junk Bonds used to be the Big Scare for financial regulators. Those are bonds issued based on revenue from risky companies with little collateral.

The bonds pay a higher interest rate, which attracts buyers, but the inherent risks are often misunderstood. It's a financial crisis waiting for the next downturn.

Now the same issues are being raised in connection with Leveraged Loans. The difference between them and Junk Bonds is that Leveraged Loans are sold off privately to pension funds, mutual funds and hedge funds. We know loans now exceed the high point of the last bubble.

Recently the Federal Reserve System and the Comptroller of the Currency have shown concern about the expansion of this market. The average debt-to-revenue of companies obtaining leveraged loans in 2014 so far has risen to a multiple of 4.9, up from 3.9 in 2011.

In other words, the total debt of new borrowers is nearly five times annual revenue (i.e., EBITDA - earnings before interest, taxes, depreciation, amortization).

It gets worse. The loan contracts have been dropping certain protections to the lenders. Of recent leveraged loans, 63 percent lack these protections, up from 25 percent in 2007. In these seemingly small ways does the quality of bank credit deteriorate.

The old Glass-Steagall wall between banking and investment banking matched up bank deposits against either liquid assets or loans subject to review by bank examiners, who have had the power to mark down debt that is substandard, doubtful or loss. Equity and risky debt was matched up with money from "sophisticated" individual investors or financial institutions. The system worked for the next 70 years until banks and non-banks both sought more freedom to do what was done in the 1920s.

Leveraged loans take on the character of investment banking. Smaller corporate borrowers like them. Bank lenders like them. But in the absence of deposit insurance, consumers of bank services would worry deeply about them.  The Glass-Steagall Act traded deposit insurance (which banks wanted) for regulatory constraints (which they did not). The constraints have been eased while taxpayers' liability for deposits - in the form of Treasury and Fed support of the Federal Deposit Insurance Corporation - has continued.

We should be concerned about Leveraged Loans as bank depositors, as taxpayer-guarantors of bank deposits, and as consumers with a stake in stable financial markets.