REUTERS/Bobby Yip
An art installation titled "Hang On a Minute Lads, I've Got a Great Idea" by British artist Richard Wilson - at The Peninsula hotel in Hong Kong, in 2015 - is based on a scene from the movie "The Italian Job".
- The total of corporate leveraged loans has hit $1.6 trillion globally, far exceeding the records set prior to the crisis of 2008.
- The loans ballooned after the Trump Administration reversed a stricter Obama-era policy discouraging high leverage.
- Now, leverage is increasing, while underlying covenant quality is decreasing.
- The US Federal Reserve, the Bank of England and the Reserve Bank of Australia have all sounded the alarm over the loans.
It is only October and already the UK economy has set a dubious new record for the year: Leveraged loans to British companies have hit about £40 billion ($52 billion), according to the Bank of England. Prior to the financial crisis, new issuances of such loans only totalled £30 billion ($39 billion).
Britain's stock of risky corporate debt is part of a trend. Globally, leveraged loans have hit $1.6 trillion, according to Institute of International Finance:
IIF
Central banks are starting to worry that the corporate world may have taken on too much debt, and that the stock of risky debt overhanging the global economy might start to behave the way sub-prime mortgages did prior to 2008.
The Bank of England recently suggested that leveraged loans might become a bigger problem than sub-prime mortgages were: "The Committee is concerned by the rapid growth of leveraged lending, including to UK businesses," the BOE's Financial Policy Committee said recently. "The global leveraged loan market is larger than - and growing as quickly as - the US subprime mortgage market was in 2006."
The Reserve Bank of Australia has the same concerns.
The amount of "leverage" - the multiples in debt that companies are getting into - is growing, too.
"If you look at leverage ratios, they are getting riskier because they are getting higher. Obviously, as a company takes on more debt it's a riskier proposition than a company that takes on less debt," said Marina Lukatsky, a director at the Leveraged Commentary & Data unit of S&P Global Market Intelligence, in a conversation with Business Insider.
In 2013, the "issuance" of new leveraged loans peaked at $607 billion. But regulators under President Obama frowned publically upon excess leverage, and the market declined through 2015 to a low of $423 billion. After President Trump took office, however, his appointees told the banking sector that they were going to be less strict about loan leverage. In 2017, new loan issuance went back up, to $650 billion - a new record.
The total of new leveraged loan issued last year exceeded pre-crisis levels by about $100 billion
Put simply, leveraged loans are given to troubled companies who can't get access to cheaper credit via a normal loan from a bank or by raising an investment-grade corporate bond. The "leverage" comes from private equity (PE) groups, who invest their own money in return for a chunk of equity in the company, in combination with the loan. The rest of the funding may be provided by banks.
The loans are then bundled and sold on private markets in the form of collateral loan obligations - bundles of debt that can be bought and sold like mortgages. The PE groups are hoping that the equity and debt investments they make are enough to turn the companies around. When that happens they can sell their stakes at a premium.
Investors have poured money into leveraged loan products because the companies who take them are required to pay higher rates of interest than they would get by holding government bonds.
Most of the loans are being made in the US.
Business Insider asked the Leveraged Commentary & Data unit of S&P Global Market Intelligence to pull its data on leveraged loans so we could get a clear view of just how big a market it has become. The numbers show the loans are becoming bigger - and riskier - over time.
Here is the total volume of new leveraged loan issuance in US dollars. Last year was a record, exceeding the pre-crisis level by about $100 billion. And 2018 will be another strong year:
LCD, S&P Global Market Intelligence
Transaction size - the total of debt and equity in leveraged loan deals - is also approaching a new peak, although it remains below the 2007 record:
LCD, S&P Global Market Intelligence
Perhaps most worryingly, the debt-to-EBITDA ratio of the average loan is once again heading toward a multiple of six, per LCD, S&P Global Market Intelligence said.
The ratio measures the amount of debt taken on by a company in comparison to its earnings before interest, taxes, depreciation and amortization. The higher the multiple, the bigger the loan in relation to the company's ability to pay it off:
LCD, S&P Global Market Intelligence
'No, no, no, no, no'
The "6x" multiple is significant. In 2013, under the Obama Administration, regulators frowned upon leveraged loans issued at six times earnings. Between 2013 and 2016, leveraged loan volume declined, and so did debt multiples.
But Trump Administration officials have been more relaxed. Issuance went up. This year, more leveraged loans were issued at over 6x.
Joseph Otting, the Comptroller of the Currency, told a financial conference in Las Vegas in February that banks could proceed beyond the old 6x level as long as they felt it was sound. "When (the idea of the) guidance came out - it was like people were afraid to jump over the line without feeling the wrath of Khan from the regulators," Otting said .
"But you have the right to do what you want as long as it does not impair safety and soundness. It's not our position to challenge that."
Later, in May, he reiterated, "I think it was always intended to be guidance," rather than a cast-iron rule
That statement was in stark contrast to the one made by Federal Reserve official Todd Vermilyea in 2014, under Obama. In a speech to bankers on whether he wanted to see corporate loans go over six times earnings, Vermilyea said: "No, no, no, no, no."
The 6x line is still an important concept in judging whether a company has taken on too much leverage, according to S&P's Lukatsky.
"The leveraged lending guidelines that were issued in 2013, they stated that if a company has a leverage issue of six times or higher, it basically raises concerns with the regulators," Lukatsky told Business Insider.
"Six times became a line, if you are above six times you are considered riskier to the regulator."
"It's kind of like you're either above or below that line," she said. "Now we're at 5.8, so we're almost there, so it is notable."
'Highly leveraged deals account for a growing share of new leveraged loan issuance and have surpassed pre-crisis highs'
The International Monetary Fund (IMF) is also worried that the number of loans over 6x are going up as a percentage of the whole.
"Notably, highly leveraged deals account for a growing share of new leveraged loan issuance and have surpassed pre-crisis highs," the IMF said recently.
"Bank balance sheets have strengthened ... but nonbank financial entities have increased their leverage, including through the use of derivatives. In the euro area, leverage in the corporate and sovereign sectors remain elevated."
This chart from the IMF shows the percentage of deals at or near 6X leverage rising over time:
IMF
A company's creditworthiness is measured by its "interest coverage ratio." The ratio measures the amount of interest a company must pay compared to its earnings. The closer a company gets to coverage of just one - in which a company's interest payments are equivalent to 100% of its profits - the worse the coverage ratio looks.
Companies' ability to cover their interest payments is better now than during the crisis, although it has recently declined, according to LCD/S&P Global Market Intelligence. Since 2014, the average interest coverage ratio has declined by 17%, from a high of 3.37 to 2.79 this year:
LCD, S&P Global Market Intelligence
As interest rates rise, companies' ability to cover their debts declines
The potential worry is that the recent decline is a sign of emerging fragility among the companies paying those debts.
Credit ratings agencies - like Standard & Poor's or Moody's or Fitch - may downgrade the quality of that debt or downgrade the creditworthiness of the companies trying to pay it. The crucial level is "BBB," or "investment grade," which signals a minimum level of quality. Once companies, or their debt, fall below BBB, they enter "junk" or "speculative" status. Many investors have a policy to automatically sell debt with that rating.
So as interest rates rise, and companies' ability to cover their debts declines, the chance of more leveraged loans falling below BBB goes up - and that could set off a downward spiral of automatic selling.
Interest on leveraged loans is typically based on a floating rate, such as a "spread" above the London Interbank Offered Rate (LIBOR). If LIBOR goes up, their interest burden goes up. Until recently, interest has been low - both the BOE and the US Federal Reserve have held interest rates near zero for years.
Spreads have been small, too. Those lowered costs have tempted more companies into taking the loans, according to the IMF.
"The share of lower-rated companies has increased because compressed spreads have encouraged the buildup of leverage," its most recent global financial stability report said.
80% of leveraged loans are now 'covenant-lite'
At the same time, the restrictions placed on companies taking the loans have become more relaxed. Usually, when a company takes a loan, it comes with a "covenant" that requires the company to maintain certain financial standards, such as ensuring that its earnings remain above a specific level in comparison to its debt. But covenants have been largely abandoned in the leverage loan market. Today, almost 80% of leveraged loans are "covenant-lite," according to the Bank of England.
That's another sign of increasing risk, S&P's Lukatsky told Business Insider. "The share of deals that are lacking typical covenant protection ... is also increasing, so there is a definite a level of risk here," she said.
"Good or bad is kind of a relative term but as far as risk is concerned, at least based on these metrics, definitely."
Anton Pil, the head of JPMorgan's $100 billion alternative investment arm, gave a presentation in London earlier this month that also worried about "covenant-lite" debt. "If you look back in 2007, we were worried about cov-lite debt in 2007, and that number was about a quarter of the market," Pil said.
"Today, it's almost 80% … If you want to worry about something in the next two or three years, this is it."
'Leveraged loans are typically sold to non-bank investors ... whose ability to sustain losses without materially impacting financing conditions is uncertain'
The Bank of International Settlements - often referred to as the central banks' bank - put this $1.6 trillion debt pile in context. The total of leveraged loans plus high-yield bonds (both are types of high-risk junk debt) on the market has reached $2.15 trillion, BIS says.
That is big enough to be a systemic threat to the stability of the global finance system, according to the most recent minutes from the US Federal Open Market Committee. The Fed did not detail its concerns, saying only: "Some participants [on the committee] commented about the continued growth in leveraged loans, the loosening of terms and standards on these loans, or the growth of this activity in the nonbank sector as reasons to remain mindful of vulnerabilities and possible risks to financial stability."
So who gets hurt if the boom collapses?
The Fed did not say, and the Bank of England admits it is not clear. But it won't be the banks. The BoE said all UK banks were now robust enough to withstand a 2008-level crisis. And, as the Fed noted in its commentary, it believes the risk is located in the "non-bank sector".
That is because banks have long since sold on the loans to less robust customers. The BOE doesn't know if those investors are strong enough to withstand their potential losses: "Leveraged loans are typically sold to non-bank investors (including to collateralised loan obligation funds), whose ability to sustain losses without materially impacting financing conditions is uncertain," it's financial policy committee said in early October.
