(Bloomberg Opinion) -- It seemed like only a matter of time before Senator Elizabeth Warren of Massachusetts, one of the fiercest Wall Street critics on Capitol Hill, joined the fray over potential risks in U.S. leveraged loans. She didn’t disappoint, blasting the $1.3 trillion market in a letter to regulators as a repeat of the subprime mortgage crisis that nearly toppled the financial system a decade ago.
This is not a particularly novel parallel to draw. After all, a large reason the leveraged-loan market has expanded is because of the insatiable demand for them to be packaged into collateralized loan obligations. Those obviously sound like the collateralized debt obligations that contributed to the financial crisis. Many market observers have taken note of this and warned that weaker investor protections are setting the stage for unexpectedly steep losses when the credit cycle turns. According to Moody’s Investors Service, overall covenant quality is worse now than in 2007 across every risk category, while average recovery rates will be worse in the next downturn than in 2008.
Warren’s letter — to Treasury Secretary Steven Mnuchin, Federal Reserve Chairman Jerome Powell, Comptroller of the Currency Joseph Otting, SEC Chairman Jay Clayton and FDIC Chair Jelena McWilliams — contains seven questions, ranging from general inquiries about their concern over CLOs to how they view leveraged lending guidance from 2013 and whether “liberalization in Volcker Rule standards could affect underwriting in the leveraged lending market.” Her message is clear: I want all of you on the record now about these securities, in case they implode.
It’s probably no coincidence that the following day, the Loan Syndications and Trading Association circulated comments intended to “dispel some of the misperceptions” about the market. The group was a bit heavy-handed in describing leveraged loans as “job-creating” securities that foster “a stronger U.S. economy,” but made some valid points. Among them:
“Some concerns stem from the market’s purported recent explosive growth. This conflates refinancing activity with actual growth. In fact, the average annual growth rate of the outstanding loan market has been a modest 7% since 2008. Furthermore, total financial leverage of companies in this market is actually below what it was in 2007.”
“CLOs, which performed extraordinarily well through the financial crisis, are long-only vehicles with no derivatives or synthetics, and are professionally and actively managed. Moreover, individuals can invest in loans only through professionally managed mutual funds which currently make up just 14 percent of the market; unlike most other instruments, individuals cannot buy loans directly.”
The LSTA then probably went too far again by concluding that “The leveraged loan market is on sounder footing today than it was in 2007,” most likely because of the total financial leverage statistic. It’s probably not the strongest argument to make just as its benchmark U.S. price index dropped last week to a two-year low. Not to mention the covenant analysis from Moody’s which says the exact opposite.
So, who’s on the right side of this debate? Maybe it’s a cop-out, but the truth is most likely somewhere in the middle. Of course individual investors shouldn’t be loading up on closed-end funds that favor the riskiest tranches of the CLO structure, as a Barron’s article suggested in July. Unlike the top-rated segments, the equity portions of CLOs are prone to severe losses and belong in the hands of hedge funds and other institutional managers.
But Warren says that further interest-rate increases from the Fed could doom the market: “Companies will face rising interest costs just as the economy starts to slow down.” It’s clear based on comments from top officials last week that they’re not in a rush and will continue to gradually tighten as long as the economy gives them a green light. That shouldn’t be back-breaking for companies with loans.
She also warns that “Many of the loans are securitized and sold to investors, spreading the risk of default throughout the system.” In truth, the packaging helps insulate buyers from pockets of distress — again, as long as they’re buying the higher-quality tranches. The AAA and even AA rated portions have famously never defaulted, even during the worst of the recession. Of course, that period wasn’t exactly a shining moment for credit ratings. But Moody’s estimates that the average recovery rate on U.S. first-lien loans will probably decline to 61 percent in the next downturn, compared with 70 percent in 2008. That should still be more than enough to keep the top of the CLO structure whole.
Warren presents a good question — perhaps the question — to Mnuchin. Who exactly is making sure things don’t go awry in this market? Here’s her full inquiry (FSOC is the Financial Stability Oversight Council):
“The leveraged lending market involves a number of different types of entities that are subject to oversight from a number of different federal regulators. Congress created FSOC to ensure adequate oversight of such cross-cutting markets. In your capacity as the head of FSOC, what is FSOC doing to monitor the growing leveraged lending market and to coordinate responses across the different agencies with relevant jurisdiction? Is the Office of Financial Research looking into the growing risks in this market?”
A crucial reason CLOs are unlikely to repeat the CDO fiasco is because the U.S. banking system is less exposed. That also means it’s largely out of the Fed’s jurisdiction. Like corporate bonds, much of the risk has been passed onto investors. And while large asset managers are certainly important, they’re not nearly as pivotal as the largest banks.
At the end of the day, anyone buying leveraged loans or CLOs at this point is well aware of their risks. For now, it’s been a winning proposition: The S&P/LSTA Leveraged Loan Index has returned 3.8 percent this year, compared with losses in just about every other fixed-income market. No one knows exactly when or how, but that momentum will fade at some point. But once that happens, don’t expect a 2008 redux. Believe it or not, markets might have actually learned a lesson.
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Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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