LegiStorm

Summary:

Leveraged lending generally refers to loans made to businesses that are highly indebted or have a low credit rating. Most leveraged loans are syndicated, meaning a group of bank or nonbank lenders collectively funds a leveraged loan made to a single borrower, in contrast to a traditional loan held by a single bank. In some cases, investors hold leveraged loans directly. However, more than 60% of leveraged loans are securitized into collateralized loan obligations (CLOs)—securities backed by cash flow from pools of leveraged loans. These securities are then sold to investors. The largest investors in leveraged loans and CLOs are mutual funds, insurance companies, banks, and pension funds. During the past decade, the U.S. leveraged loan market experienced periods of growth; it grew by 20% in 2018, bringing the amount outstanding to more than $1 trillion. According to some industry observers, deteriorating credit quality and decreasing investor safeguards have accompanied this growth; however, default rates have remained low. The share of leveraged loans originated by and held by banks has declined, whereas the roles of nonbank participants, such as investment management and finance companies, have increased. In addition, some observers have noted similarities between leveraged lending and CLO market characteristics and those of certain mortgage lending and mortgage-backed securities (MBS) markets in the lead-up to the 2007-2009 financial crisis. As a result, leveraged lending has raised a number of interrelated policy issues. Observers express concerns that leveraged lending presents certain financial and economic risks, as both a potential source of systemic risk and a mechanism that could exacerbate a future recession (even if it does not cause financial instability). Leveraged lending could pose systemic risk because it couples high risk with opacity, potentially leading to unexpectedly high losses and financial disruption. Some experts have argued that potential leveraged loan losses or illiquidity could lead to contagion effects, wherein one financial firm's distress affects other firms and activities. However, banks' limited exposure to leveraged loans and stronger postcrisis capital and liquidity positions might mitigate contagion effects. For these reasons, some financial authorities (e.g., the chairman of the Federal Reserve) have indicated that although leveraged loans raise some concerns, they "do not appear to present notable risks to financial stability." Even if leveraged loans do not cause financial instability, some nonfinancial firms that rely on leveraged lending could lose access to financing during the next downturn, which could negatively affect their operations if they were unable to find alternative funding. Overall borrowing by nonfinancial firms is historically high, which could lead to a larger-than-normal cutback in their spending or more corporate failures in the next recession, exacerbating that recession. Some assert that because certain leveraged loans, such as those involved in private nonbank transactions, face different regulation than leveraged lending by banks and comparable bond issuances, the market might be ineffectively regulated. In addition, some analysts have argued that a lack of transparency in the leveraged lending market prevents the industry and regulators from fully monitoring risks that could be addressed through increased data collection and sharing. To date, Congress and the financial regulators have mainly limited the policy response to leveraged lending to monitoring risks. A more active regulatory intervention would be complicated by the fact there are few specific regulations governing leveraged lending. (One exception is a supervisory guidance issued by bank regulators in 2013, which the regulators have stressed is nonbinding but the Government Accountability Office declared to be a regulation for Congressional Review Act purposes in 2017.) Addressing systemic risk is under the purview of federal financial regulators, including the Financial Stability Oversight Council (FSOC), an interagency council headed by the Treasury Secretary. Although FSOC recommended in its 2018 Annual Report that the financial regulators "continue to monitor levels of nonfinancial business leverage, trends in asset valuations, and potential implications for the entities they regulate," it did not recommend regulatory or legislative changes to address leveraged lending.