The Washington Post’s recent article, How regulators, Republicans and big banks fought for a big increase in lucrative but risky corporate loans, paints a simplistic and inaccurate portrait of what is going on in the leveraged lending industry. The article’s basic narrative is that previous regulators were trying to prevent banks from taking improvident risks but Members of Congress, the banks, the current financial regulators and even the GAO are stymieing them, leaving the country on the precipice of a new financial crisis.
Given the importance of that industry, which is a multi-trillion dollar source of funding to America’s growing mid-sized businesses, it is worth setting the record straight. Some examples:
There is no universally agreed definition of leveraged loans, but they are generally understood to be loans to companies that are already highly indebted or have a speculative-grade credit rating. The current market is approximately $2.3 trillion. The article describes companies who take out leveraged loans as “cash-strapped.” Another term might be “growing” and in need of financing. According to data from the Loan Syndications and Trading Association, 34% of leveraged loans are used for refinancing, and another 48% for mergers and acquisitions and leveraged buyouts – inconsistent with the portrait of desperation painted by the Post.
The primary focus of the article is efforts to reform or invalidate guidance issued by the federal banking agencies in 2013, and FAQs issued under that guidance in 2014. The agencies treated this “guidance” as a binding regulation yet neither issuance was submitted to Congress under the Congressional Review Act, and the FAQs (which were more binding, and set explicit caps on lending) were not published for public comment. The GAO, a non-partisan arm of Congress, determined that the guidance was, in fact, a “rule” under the Administrative Act, and therefore the failure to submit it to Congress for potential disapproval made it invalid.
Leaving aside it’s legal failings, that guidance had serious substantive problems — none noted by the Post.
- The original guidance and FAQs issued by the agencies used overbroad formulas that swept in companies that were investment grade – so, pretty much by definition not “cash strapped.”
- More importantly, the guidance was issued in 2013 based on the premise that at that time the leveraged lending market was on the verge of collapse. Bankers disputed that premise; the regulators overruled them. The regulators were clearly wrong — something that none of the regulators quoted in the article bothers to acknowledge – as there has been no evidence of disproportionate losses in that market.
- Of course, that is not to say that there will not at some point be losses in the leveraged lending market — all bear market calls are eventually right. The question is how much economic growth is lost by the regulators restricting bank participation in this market, and what the financial stability consequences of the eventual losses will be.
- This brings us to another key fact omitted from the Post’s narrative. There is nothing necessarily wrong with investors losing money on leveraged loans — or tech stocks, or real estate developments, or gold, or tulip bulbs, or any other asset. Those losses become a financial stability problem, as they did with mortgage losses in the financial crisis, only if they are financed by short-term debt — in other words, if a decline in the value of the asset requires the holder to sell it to meet maturity liabilities, depressing the price and triggering further sales by that firm or other. Leveraged loans, however, generally are not held by leveraged investors. In fact, on March 19, 2013, just days before the leveraged lending guidance was issued, Nellie Liang, director of the Office of Financial Stability, told the Federal Open Market Committee:
Although recent trends could imply significant losses in the future for some leveraged finance investors, as noted in the bottom left, we do not currently see a reemergence of financial leverage to fund risk positions or large bank exposures, some of the amplification channels that were evident in the crisis.
Again, this vital fact is missing from the Post’s reporting.
The Effect of the “Guidance”
There is another reason to question the wisdom of the agencies’ guidance: it failed on its own terms. Recent studies – including one by Federal Reserve staff – conclude that the risk has simply migrated out of the banking sector; thus, the only effect of the agency guidance was to shift the risk to where it is not subject to regulatory capital requirements or prudential oversight.
- The Post makes no mention of this study, and others in the same vein. Two papers by Fed economists concluded that while the guidance lowered banks’ originations of leveraged loans, it also led to a migration of leveraged lending to non-banks.
- The Post reports that “many banking executives say their institutions are sheltered from losses because they sell the loans to other investors such as hedge funds, mutual funds and insurance companies.” It is puzzling why all banking executives wouldn’t say as much, as that is precisely the goal.
- The Post also ignores numerous examples of overbreadth in the guidance, while criticizing any attempt to revise it as an attempt to “undercut” or “water down” good policy and “juice” the economy by (heaven forbid) “encouraging more lending.” For example, however, it is difficult to understand why the guidance did not allow banks to net cash on hand against debt in computing how leveraged a company was. (So, even companies that were by definition not “cash strapped” were treated as such.) Bridge loans were treated as leveraged loans even if they were to be shortly replaced by a bond issuance. All of this nuance, well reported elsewhere, was lost in the Post’s Manichaean treatment of the subject.
The Effect of Invalidating the “Guidance”
The Post continually suggests that the GAO’s legal conclusion that the guidance was procedurally defective and therefore unenforceable has led to a dramatic increase in such lending that was not possible before a change in regulatory agencies. The article states that over the past two years regulators have paved the way for banks and other financial companies “to issue more than $1 trillion in risky corporate loans.” Certainly, the leveraged lending market has grown, but has the risk at banks?
- Banks don’t really “issue,” they originate or make loans, which they may then either hold or sell. In the case of leveraged loans, banks originate them but generally retain only a portion, and generally the higher quality tranches of any security eventually backed by those loans (collateralized loan obligations, or CLOs). “Issue” confuses those two.
- Indeed, all of the largest banks described this risk in their most recent earnings calls. A verbatim excerpt of those calls is appended here. The portrait they paint is utterly inconsistent with their reporting in the Post.
- Also not mentioned in the Post article: as discussed here, the most recent Shared National Credit review report from the federal banking agencies contains no statistical evidence that risks associated with leveraged loans held by banks have increased over the past year, and some evidence that they have decreased. Other data show that as of 2018, interest coverage on the loans (profits available to repay the loan) was at a 10-year high.
- The Post states that leveraged borrowers tend to fall behind “when interest rates go up.” In fact, many borrowers are contractually obligated to hedge their interest rate exposure. One trusts that banks, investors and regulators are aware of the residual risk.
Clearly, the leveraged lending market is very important, and the risks it presents are real and complex. (The same is true, by the way, for the high-yield bond market, which presents a very similar set of issues, but yet has not proven controversial, perhaps because banks do not underwrite the securities.) That is precisely why regulation of it should have been debated through the public process the law requires, and submitted to Congress for its review, rather than through issuances labeled as guidance but treated as binding rules.
At BPI (and our predecessor firm, the Clearing House Association), we were quite overt and insistent in criticizing the procedural failings with the guidance.
We are quite heartened that the GAO has vindicated the rule of law, and the value of transparency in rulemaking. We are confused about why the Post would suggest otherwise.
As a final note, and as all of the data and studies above should indicate, the risks of this market are under intense study by regulators, investors, and banks. As noted above, in 2013, the Fed was already considering who was holding this risk and what the ramifications of losses would be for financial stability. The Post’s article stated that it interviewed 31 people, and “Most conceded they had no idea what would happen to the economy when defaults on these loans spike.” It seems they interviewed the wrong people.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.
 Transcript of the March 19-20, 2013, meeting of the Federal Open Market Committee, p. 25.
 See Kim, Sooji, Matthew C. Plosser, and Joao A.C. Santos “Macroprudential Policy and the Revolving Door of Risk: Lessons from Leveraged Lending Guidance,” May 2017, Federal Reserve Bank of New York Staff Reports, no. 815. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr815.pdf?la=en;
Calem, Paul, Ricardo Correa, and Seung J. Lee,” Prudential policies and their impact on credit in the United States,” December 2016, International Finance Discussion Papers.