Office of Financial Research Slams Leveraged Loans
The 2014 Annual Report of the research arm of the Financial Stability Oversight Council1 covers many areas of finance that may threaten financial stability. The report is rather straightforward and surprisingly easy to understand, perhaps because the report is submitted to Congress. The section on leveraged loans received more media attention than we expected, and while the entire report is worth skimming in your vast amounts of spare time, we appreciated in particular the hard numbers provided in the report on the leveraged loan situation (see pages 20-22 of the report, which are pages 26-28 of the PDF).
If the term “leveraged loan” is new to you, click here for an excellent primer.
A few highlights from the report:
“The combined issuance of collateralized loan obligations — securities backed by pools of corporate loans — and leveraged loans, which are higher-risk bank loans often sold to institutional investors, has exceeded the peak levels of the last credit cycle. Bank regulators are clearly aware of the buildup in credit risk and have responded with guidance and exhortations to banks….”
Okay, great. The bank regulators are on that sucker and will keep those boys in line. But what happened was…
“Nonbank lenders have increased their credit exposure significantly since the financial crisis and engage in riskier deals than banks because of low interest rates. … Short-duration funds, which invest in leveraged loans, have shown the most significant growth. Assets under management have increased ten-fold over the last five years, driven by a search for yield and a hedge against an eventual rise in interest rates. In sum, much of the recent growth in credit risk-taking is concentrated in nonbank entities that are not directly regulated by banking supervisors.”
Let’s also discuss the various new financial products hitting the street:
“Product innovation has also increased in corporate credit markets, a hallmark of late-stage credit cycles. Recent issues have provided broader, cheaper access to credit such as exchange-traded, high-yield, and leveraged loan funds; total return swaps on leveraged loans; and synthetic collateralized debt obligations. This development contrasts with limited innovation elsewhere in the financial system.”
ETFs and mutual funds purchase the leveraged loans with investor money, and the danger is that if a large enough number of investors want to sell their shares of the fund (go to cash) at one time, the manager may have no choice but to liquidate the loans at the current price in order to raise cash to return to the investors. Usually this sort of thing would occur at a time when prices have fallen noticeably, as outflows from mutual funds usually occur after a significant price drop, i.e., buy high, sell low. The forced liquidation pushes the value down further, causing more outflows, causing more forced liquidations by the fund. And down we go.
To read the full report of the Office of Financial Research, click here.
1. In the aftermath of the financial crisis, Congress created the Financial Stability Oversight Council at the U.S. Treasury Department in the continuing effort to appear to be making sure nothing like the housing/banking crisis ever happens again despite prior actions by Congress being one of the primary causes of said housing/banking crisis. The Council’s research arm publishes an annual report on problems with the structure of the financial system, which Treasury Department regulators attempt to regulate before moving on to their next job, usually at one of the financial institutions they were regulating, working with the new regulators who replaced them.
