Regulators want banks to tighten the underwriting of leveraged loans — a type of high-risk, high-yield financing offered to debt-laden companies that is experiencing a resurgence.
The funding is often used by private-equity firms, such as District-based Carlyle Group, for buyout transactions or corporate acquisitions. Other firms use the debt for recapitalizations or refinancing. Big banks, including Wells Fargo and Bank of America, are the dominant lenders in the market, and the focus of new guidance.
“While there was a pull-back in leveraged lending during the crisis, volumes have since increased while prudent underwriting practices have deteriorated,” the Office of the Comptroller of the Currency, Federal Reserve and Federal Deposit Insurance Corp. said last week when announcing a joint proposal urging banks to be more cautious in making loans.
The proposal, an update of guidance issued in 2001, focuses attention on five areas: establishing a sound risk-management framework; underwriting standards; valuation standards; pipeline management; and reporting and analytics.
One of the biggest changes would urge that banks establish a plan to address failed transactions and general market disruption, said Bram Smith, executive director of the Loan Syndications & Trading Association, an industry group.
“Regulators are looking at the diversification of deals, the size of transactions or the variation of credit quality to manage the pipeline of transactions,” he said.
Smith said regulators are trying to avoid a repeat of 2006 to 2007, when banks agreed to so-called “covenant lite” loans that provided limited protection when companies defaulted.
Much of the new guidance is the same as in the previous iteration, but the regulatory agencies are now asking banks to be more judicious in vetting borrowers. Transactions, they say, should be structured to reflect “a sound business premise, an appropriate capital structure, and reasonable cash flow and balance sheet leverage.”
While the guidance is not enforceable, it gives examiners a basis for tougher oversight of leveraged loan portfolios.
Leveraged loan volumes soared 59 percent over 2010 to $373 billion last year, the highest level since 2007, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.
The agencies are accepting public comments on the proposal until June 8.