US banks' `leveraged loans’ to heavily indebted companies pose major risks, regulators say

US bank syndicates’ high-interest loans to heavily indebted companies pose credit risks that are “high and increasing,” banking regulators said.

While most of these “leveraged loans” are held by hedge funds, insurers and other nonbanks, the share held by US and foreign banks rose from 35 percent to 45 percent last year due to the pandemic, the Shared National Credit Program review said.

“Many loans possess weak structures,” said the report by the Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency. “These structures often contain layered risks and include some combination of high leverage, aggressive repayment assumptions, weakened covenants, or permissive borrowing terms that allow borrowers to increase debt, including draws on incremental facilities” (see here).

A substantial portion of the $5.1 trillion total in syndicated loans, or loans of at least $100 million shared by three or more banks, had weaknesses or potential weaknesses, the report said. These substandard loans rose from 6.9 percent of all syndicated loans in 2019 to 12.4 percent in 2020.

— Banks’ risk management —

The report addressed the ability of banks, but not nonbanks, to manage the risks from holding these loans.

“Many agent banks have strengthened their risk management systems since the prior downturn and are better equipped to measure and monitor risks associated with leveraged loans in the current environment,” it said.

Banks accounted for growing ownership of leveraged loans due to downgrades in oil and gas markets, retail businesses, and commercial real estate affected by the pandemic, the report said. Businesses in these sectors tend to take out loans held by banks.

Regulators have little data on the insurers, mutual funds, and securitization vehicles such as collateralized loan obligations that hold most leveraged loans.

“Little is known,” the global Financial Stability Board said in December 2019, “about the direct exposures of certain nonbank investors to these markets.”

Leveraged lending, in addition to providing credit to heavily indebted businesses, also typically helps mid-sized companies get funding for leveraged buyouts, mergers and acquisitions, and business recapitalizations.