Sunday, June 1, 2014

Failure of Guidance on Leveraged Lending resembles the War on Drugs

About two years ago the various US bank regulatory agencies (the OCC, the FDIC, and the Fed) have started pushing through the so-called Guidance on Leveraged Lending. They were alarmed at the rising leverage and weaker covenants (see post) in new sub-investment grade corporate finance transactions that involved senior loans.
US Regulators (March 2012): - Credit agreement covenant protections, including financial performance (such as debt to cash flow, interest coverage or fixed charge coverage), reporting requirements, and compliance monitoring. Generally, a leverage level after planned asset sales (i.e., debt that must be serviced from operating cash flow) in excess of 6x for Total Debt/EBITDA raises concerns for most industries.
The guidelines ultimately went into effect, as US regulators made it known that they will be watching these transactions closely. Particular emphasis has been given to the "6x" leverage cutoff that regulators view as the "danger zone".
Bloomberg (October 2013): - The Federal Reserve and the Office of the Comptroller of the Currency sent letters to some of the biggest U.S. banks asking them to avoid arranging debt that may be classified by regulators as having some deficiency that may result in a loss, according to nine people with knowledge of the communication.
Of course a great deal of this paper is not held on banks' balance sheets and instead sold to CLOs, traded loan funds, and other asset managers. What the regulators fear however is that a major market disruption will prevent banks from unloading this risk, resulting in "hung" deals that could jeopardize bank stability.

Recently, Deutsche Bank researchers took a closer look at how effective the Guidance on Leveraged Lending policy has been. What they found so far is that this regulatory effort does not seem to have much of an impact at all, as the percentage of loans with leverage of 6x and above continues to rise.

"Pct of Deals" = percentage of  the number of leveraged finance transactions with leverage > 6x
"Pct of Face" = percentage of  the face value of leveraged finance transactions with leverage > 6x
Deutsche Bank: - Aggressiveness of new deals has been rising consistently over the past few years, and currently stands at levels similar to those last seen in 2006 as measured by both of these datasets.
Part of the problem with this failed regulatory effort is its similarities to the so-called War on Drugs. The demand for yield has been so strong lately that cutting off supply remains extremely difficult and will take time. Instead the Fed should be focusing on the demand side of the equation. By raising interest rates more aggressively, the Fed could improve fixed income yields, thus reducing the need to chase such high-risk paper.
Deutsche Bank: - ... while we realize that it takes time for the market to conform to new leveraged guidance and future disciplinary actions by regulators will help such an adjustment gain its urgency, the single most important action the Fed can take in addressing these trends is to continue normalizing monetary policy faster rather than slower. The reach for yield in leveraged finance, after all, is primarily a function of scarcity of yields in other markets.
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