US banking regulators warn of risks in leveraged loan market

Risks associated with the leveraged loan market are still “high” despite marginal improvements in corporate creditworthiness in 2021, top US banking regulators have warned.

In a report released on Monday, the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency flagged mounting vulnerabilities across a number of sectors hardest hit by the coronavirus pandemic, including commercial real estate. Most of the riskiest loans, they warn, are held by non-bank financial entities.

Companies across the credit spectrum have rushed to borrow cash in recent years, initially to build a buffer to outlast the pandemic and later to refinance their borrowing at lower rates of interest.

That has resulted in a swelling of corporate debt piles, with credit even extended to the lowest rated companies, fuelled by investor demand for higher-yielding assets and bolstered by the Fed’s historic intervention in financial markets.

But the regulators warned a large number of borrowers remain constrained in their ability to repay debts.

“While some leveraged borrowers have adjusted to the economic impact of Covid-19 and show signs of recovery, other borrowers with elevated leverage remain especially vulnerable,” according to the Shared National Credit Review report.

The total number of loans falling short of a pass rating by regulators has swelled during the pandemic.

They include so-called special mention loans, which have “potential weaknesses that deserve management’s close attention”, and classified commitments, defined as loans that are “substandard, doubtful, and [uncollectible]”. 

The total number of special mention and classified commitment loans decreased by about $80bn in 2021 from the previous year to $550bn, but still represent north of 10 per cent of all credit commitments assessed by the SNC.

The report also warned about the number of loans with “weak structures”, including high leverage, aggressive repayment schedules and terms that allow borrowers to increase debt.

“The volume of leveraged transactions exhibiting these layered risks increased significantly over the past several years and continues to grow as strong investor demand for loans enabled borrowers to obtain less restrictive terms,” the report said.

Non-bank financial groups are exposed to more than $300bn of the total $550bn of special mention and classified commitment loans, with roughly a quarter of the total committed by the institutions, meaning they are on the hook for it. By comparison, just over 12 per cent is committed by US banks and foreign banks.

The trajectory of the pandemic will determine the “direction of risk” this year, the regulators said, with inflation, supply chain imbalances and labour challenges heaping additional pressure on indebted companies.

They also flagged vulnerabilities associated with rising interest rates, which they cautioned may “negatively impact” both the “financial performance and repayment capacity of borrowers in a wide variety of industries”.