Leveraged Loan Levels Cause Concern on Wall Street
Securitized debt can be a valuable tool, as it increases borrowing efficiency by placing debt more efficiently. Lenders need to have a good understanding of the risks involved though.
Businesses raise money three main ways, by issuing stock where they get paid the issue price when their stock gets placed in the market, by issuing bonds or other securities that they pay interest on to the bearer, and by the way we do it ourselves, by taking out loans.
Just like us, the interest that companies pay on their loans depends on the combination of their credit rating and where interest rates are at. These loans are based upon a spread with an interest rate benchmark like the LIBOR, and as interest rates rise, the cost of servicing the debt goes up in tandem, and this is the main reason why the stock market prefers lower rates and absolutely hates higher ones.
Companies take out loans for three main purposes, to expand their business, to restructure their balance sheets where one debt is replaced by another, and to buy stock. The use of buying stock actually comprises a lot bigger percentage of these loans than one may think, but this is how companies take each other over, and they also use these loans to buy back their own stock as well.
Just like when we buy stock or other securities on margin, where we put up some of the money and borrow the rest, pledging the securities we buy with the money as collateral, companies do this as well, and really need to because they simply don’t have the means to borrow the money that they need to do these purchases otherwise, or have the cash on hand to do it themselves.
Given that these loans are collateralized, businesses can also borrow a lot more by this means than they could otherwise. This is similar to our opening up a trading account and be allowed to buy on margin, where our broker doesn’t really look into our credit rating because they hold a claim on the assets that we buy and have the right to call in the loan, a margin call in this case, if they need to.
Leveraged Loans Also Leverage Risks
Buying on margin, or with leveraging, can be a powerful tool both for traders and investors and for companies as well, in the right circumstances that is. Leveraging increases both return and risk with investments, and while increasing our returns is an exciting prospect, we also need to properly manage the risk side here as well.
Leveraged borrowing also offers more flexibility to borrowers, and capital markets, like all markets, serve to facilitate both sides of transactions, and will in this case more readily bring together borrowers and lenders and allow them to strike up terms that are mutually acceptable.
This process also includes selling loans on the secondary market, like the mortgage backed securities that we saw get massacred during the housing crisis of 2007. Credit markets prepackage loans as well, including these leveraged loans that companies take out, and like mortgage backed securities, they do make it to the grass root level as well and even everyday investors take on this debt through it being packaged in funds they purchase, or with their pension fund investing in them.
There are two main things to look at as far as risk goes with these leveraged loans, starting with default risk, the risk of not being able to pay it back due to changing circumstances. For instance, if you buy stock on margin, and your stock doesn’t perform well, that represents a risk, and if the risk gets too great, you get a margin call.
The second element to this, one that doesn’t really apply very much to our own trading, although it still does matter if our margin rates were to rise enough, is interest rate risk. These two types of risk may seem independent, but can both be present, if rates go up and selling starts to happen in response to it, and if this is broad enough, this can affect the expectation of the assets held as collateral and lead to defaults.
What We Need to Worry About with Leveraged Loans
There are two main worries if things go wrong, which are the impact of defaults that occur, and the devaluation of assets that go with it. An easy way to understand this is your owning stock in a company which gets over-leveraged, and their stock needs to be sold off, leaving your shares are now worth quite a bit less.
Corporate debt in general has been rising over the last several years, and it has risen from $4.7 trillion in 2007 to $9.1 trillion today. Leveraged lending has also grown, and we’ve also migrated away from banks toward non-bank lenders, such as funds, which now comprise 91% of leveraged lending.
All this new interest in lending has also served to relax the terms of a lot of these loans, called covenant lite loans, which are called this because they are lighter on covenants that protect lenders. Covenant lite loans now represent almost 80% of all leveraged loans. Companies take advantage of the relative lack of understanding of risk that non-bank lenders have to strike up better terms for themselves.
This also has us with a lot more securitized debt out there. By moving this lending away from banks, this has served to both obscure the risk involved and place risk management in the hands of non-experts, like the investors who bought mortgage-backed securities back before they crashed, without much of an idea of what they were getting into.
With all this as a backdrop, we can see how this could be a problem, and the current situation has really started to concern some people, including former Fed Chair Janet Yellin.
The concern isn’t that this in itself produces trouble, it’s what may happen if enough trouble surfaces, where the impact of the events that cause the downturn will be amplified. Yellin describes this as “a danger that if there’s something else that causes a downturn, the high levels of corporate leverage could prolong the downturn and lead to lots of bankruptcies in the non-financial corporate sector.”
Yellin also points to the dangers of securitization here, although we are talking about a different animal here than the debacle with mortgage backed securities she reminds us of. The risk with MBS was extreme, and the main reason was that they were doomed to crash if housing prices sank, causing the collateral that secured these mortgages to just evaporate before our eyes.
We could see something similar happen with leveraged loans, although both the risks and the damage would be less. We could call this systemic risk lite, but there is some systemic risk out there with this, the prospects of such a thing bringing down the entire house to the degree that it suffers, like MBS and other credit defaults did when the housing bubble burst.
If we let the market decide entirely, like we did with MBS, the opaqueness of the risk involved with these securities can extend risk levels beyond what would normally be seen as acceptable, and while securitization is a useful tool, it can also overextend things by quite a bit.
This is not to say that we’re necessarily that overextended now, but some people do think so, including Anton Pil of J.P. Morgan Asset Management, who remarked on Wednesday that “this will end poorly.”
Yellin does not see any serious threat on the horizon yet though, although interest rates going up enough would change this. She tells us that the riskier loans are not leveraged, and the leveraged ones appear safe enough for now at least. Loan defaults of any sort can be a problem though, given how connected things are now, but at least don’t directly lead to the mass dumping of assets that is the main fear of leveraged loans gone bad.
The only real response to a free market that is seen to be taking too many liberties is to use regulation to restrain it, and while there may not be a call for all that much yet, we may be able to do a better job to at least narrow the knowledge gap between bank and non-bank lenders, sufficient to better ensure that all lenders have a good enough idea of what they are getting into.
Editor, MarketReview.com
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