The Sunday Telegraph - Business & Money
Bank raises alarm over junk debt
From the Bank of England to Wall Street, a leveraged loans explosion has set off alarm bells, finds Tom Rees
FEARS are mounting that the $1.4 trillion risky loan market could lead to a subprime mortgage-style meltdown after Bank of England research caused shock waves at the world’s top central banks.
Financial stability experts on Threadneedle Street were the first to reveal exposure to leveraged loans that fund the most indebted companies.
The Bank revealed that banks, insurers and pension schemes have amassed a $405bn exposure to collateralised loan obligations (CLOS), packages of the junk-rated debt. It is understood the Bank’s analysis raised fears among policymakers at the US Federal Reserve and the European Central Bank.
Mark Carney, Bank of England Governor, warned MPS this week that leveraged loans have “all the hallmarks” of the subprime mortgage bubble that triggered the financial crisis. He admitted in a Treasury Committee hearing on Wednesday that he was “concerned” about the “rapid” pace of growth in the market.
The Bank said in its November financial stability report the risky loans had fuelled a worrying rise in corporate leverage. The debt boom could “amplify economic downturns” and lead to “deeper recessions”, it predicted.
The rapid growth of the market has been driven by investors searching for higher returns in the ultra-low interest rate environment. Central banks and credit ratings agencies believe fierce demand for the loans has led to a huge deterioration in investor protections.
Covenant-lite loans now make up a record four fifths of the loans and investors need to brace for lower recovery rates in a default, Moody’s has warned. Analysts believe the dominance of “cov-lite” loans will lead to a much longer default cycle in the next economic downturn.
Toys R Us and Sears buckled under the weight of their leveraged loans last year, while these below investment grade loans also fund household names such as Uber and American Airlines. Former Federal Reserve chairman Janet Yellen echoed Mr Carney’s concerns in December, arguing that leveraged loans are “systematic risks”.
“There are a lot of weaknesses in the system and instead of looking to remedy those weaknesses I feel things have turned in a very deregulatory direction,” she said.
‘You can hear the ghosts of subprime mortgages clanking their chains,” an alarmed MP told Mark Carney on Wednesday. The Treasury committee grilling had been dominated by no-deal preparations after a night of Brexit drama, but a much bigger threat to the financial system was troubling Carney and the Bank of England. The Governor warned that the lucrative leveraged loan market has all the hallmarks of the explosive subprime mortgage crisis, the first domino to fall in the run-up to the Great Recession. “The pace of growth has been quite rapid for some time,“he said to MPS. “We are concerned.”
These junk-rated loans are issued by debt-soaked corporates at enticing rates, offering investors relief by tracking central bank interest rates higher. They’re packaged up in collateralised loan obligations (CLOS), given a top credit rating and sold on to yield-hungry investors starved in the ultra-low interest rate environment. Sound familiar?
Central bankers and Wall Street’s top figures are beginning to turn their heads to this booming corner of the credit market, concerned that the echoes of the subprime crisis are too eerie to ignore. Leveraged loans racked up a mantelpiece of worrying milestones in 2018. A market funding the most indebted companies and private equity deals was allowed to balloon to a record size of $1.35 trillion (£1.04 trillion), according to LCD, S&P Global Market Intelligence. Investor protections on leveraged loans plunged to new all-time lows. And post-crisis rules were ditched that forced sellers of potentially toxic CLO packages to have skin in the game.
Former Fed Reserve chairman Janet Yellen said last month the loans could ignite “systematic risks”, highlighting the “huge deterioration” in loan terms. And JP Morgan boss Jamie Dimon argued this week that borrowers will be stranded in the next recession.
“Someone’s going to get hurt there,” the Wall Street stalwart warned, noting that the risk was building outside the traditional banking sector in shadow banking.
If their worst fears are correct, a disturbing array of investors are exposed to losses, according to Bank of England data. In the hunt for yield, even insurers and pension funds – which usually seek safer assets – have been tempted by CLOS worth around $150bn.
“A lot of these companies are zombies, they keep borrowing money from lenders but they are not really investing in the employees or the business,” explains Mayra Rodriguez Valladares, of financial risk consultancy MRV Associates.
“Eventually these companies are going to implode.”
Toys R Us and Sears collapsed under the strain of its pile of leveraged loans while Uber and American Airlines have also issued debt in the market.
The intense demand for leveraged loans has driven a rapid deterioration in basic investor protections. Covenant-lite loans now make up around four-fifths of the leveraged loan market, according to Moody’s. These covenants force borrowers to pass financial health tests, stipulating how much debt a company can take on or the earnings it needs to generate.
Default rates on leveraged loans are currently tiny but the ditching of covenants means that corporate zombies stagger on without triggering a warning sign on the way to ruin.
Credit ratings agencies have also warned that investors are ill-prepared for far lower recovery rates – the amount they claw back in a default. Moody’s expects first-lien loans – the first in line for payment in a default
– to recover just 61pc, compared to the long-term average of 77pc.
Defenders of the market argue that in some cases a lack of covenants can stop a company defaulting when its earnings sink during a natural downturn. Ruth Yang, of LCD, S&P Global Market Intelligence, also explains that the maturity wall on these loans is “pretty far out … between three to five years”, meaning that borrowers will not face a wave of debt to pay for in the immediate future. She adds that the “deep” CLO market and funding for these indebted companies is unlikely to dry up.
However, analysts almost unanimously agree that the borrower-friendly market has now reached its peak. The next default cycle will be exacerbated by this loosening of protections if the global economy takes a really nasty turn, says Yang.
“The credit crunch really lasted only 20 months, we see a default cycle over three, four or even five years with lower recoveries. Because there is so much debt in the market the amount of defaults to debt would really be quite high at a lower [recovery] rate.”
While policymakers needed to take the heat out of the market, an eagerness in the US to liberate Wall Street from Obama-era restrictions risks the opposite. A US appeals court ruled last year that CLO managers who packaged up the debt no longer have to hold any of the risk they sell to others. The first cracks in the leveraged loan market started to show in December. As fears mounted on markets of a looming recession, leveraged loans suffered their worst loss last month since mid-2011 as funds saw record outflows and junk debt markets were completely paralysed.
“A lot of the concerns are that it definitely feels like we are close to where we were 10 years ago before the credit crunch,” says Yang.
She warns there are growing fears that “what happened last time could happen again”.
‘A lot of the concerns are that it feels like we are close to where we were 10 years ago before the crunch’