Now, regulators and even White House officials are struggling to comprehend the scope and potential dangers of the massive pool of credits, known as leveraged loans, they helped create.
Goldman Sachs, Wells Fargo, JP Morgan Chase, Bank of America and other financial companies have originated these loans to hundreds of cash-strapped companies, many of which could be unable to repay if the economy slows or interest rates rise.
“This means that the next downturn that we have could be more serious and longer-lasting and more difficult to deal with than it would have been if we had constrained these practices,” former Federal Reserve chair Janet L. Yellen said in an interview.
The lending boom was precipitated, in part, by the rush to water down regulations at the start of the Trump administration. That’s when newly minted regulators — many with close ties to the financial industry — sought to strip away post-crisis financial rules and find ways to juice the economy by encouraging more lending.
One of their top targets was leveraged loans. These are giant loans that banks make to heavily indebted — in financial speak, highly leveraged — companies. Bankers often have little assurance that the loans can be repaid, which can make them particularly risky. Bankers earn large fees off these products, and many banking executives say their institutions are sheltered from losses because they sell the loans to other investors such as hedge funds, mutual funds and insurance companies.
By freeing banks to make more of these loans, regulators allowed more money to be pumped into the economy. White House officials believe this helped achieve President Trump’s goal of growing the economy faster in the first half of his term.
This article is based on interviews with 31 current and former bank regulators, senior administration officials, congressional aides, bankers and market analysts. Some of them spoke on the condition of anonymity to discuss internal government deliberations.
Most conceded they had no idea what would happen to the economy when defaults on these loans spike.
This tension between easy money and unknown risks has flummoxed some of the very officials who have allowed the lending binge to heat up since 2017. In an appendix to its annual budget, White House officials in March touched on both the benefit of leveraged loans and the potential that they could cause a repeat of the financial crisis in 2008 and 2009.
“Lending has increased, which is a positive development, but care must be taken that excessive leverage and risk do not reprise the mistakes of the 2000s,” the report said.
A warning to banks
In 2011, two years after the end of the financial crisis, a seasoned bank examiner thought he saw a worrying trend.
Banks were dipping their toes back into a risky type of corporate credit called leveraged lending.
The official, Timothy Long, was chief national bank examiner at the Office of the Comptroller of the Currency (OCC). He issued warnings to other examiners to keep their guard up and prevent banks from taking on too much risk with these loans.
Long, in an interview, said banks were often attracted to making leveraged loans because of the huge fees they could earn.
But these loans are high-risk. They’re made to borrowers who have access to less cash than others, and who tend to fall behind on payments with greater frequency when interest rates go up or the economy slows down.
“Over the past 35 years, these are some of the worst underwritten loans in the bank,” Long said.
Long retired later in 2011. Two years later, the OCC joined with the Federal Reserve and Federal Deposit Insurance Corp., the main banking regulators, to issue formal “guidance” meant to steer banks away from the riskiest of these loans, cementing Long’s warning into a firmer policy.
“In particular, financial institutions should ensure they do not unnecessarily heighten risks by originating poorly underwritten loans,” the regulators wrote in the guidance. “[A] poorly underwritten leveraged loan . . . may generate risks for the financial system.”
While “guidance” is not an order that banks act in a certain way, historically firms have complied, as they try to avoid clashes with regulators.
The guidance wasn’t the only warning issued by regulators.
In a report the next year, regulators revealed “serious deficiencies” in the way that leveraged loans were offered by banks. It found 31 percent of the loans offered by banks during the previous 12 months were considered “weak,” meaning they are poorly executed and at a high risk of default. It also found that 75 percent of all the banking industry’s substandard assets were leveraged loans.
In addition, the Federal Reserve warned Credit Suisse that it should be more cautious about making risky leveraged loans, according to media reports at the time.
A Credit Suisse spokeswoman, Karina Byrne, said the company does not “comment on any of our specific interactions with our regulators.”
This new regulatory push sent shudders through the banking industry. Financial companies dialed back their leveraged lending, according to industry data. Issuance of these loans fell from $607 billion in 2013 to $423 billion in 2015, according to S&P Global Market Intelligence. Private equity firms complained that it was harder to obtain loans for leveraged buyouts.
Bankers, upset about losing out on millions of dollars in fees, started complaining to regulators and congressional aides that regulatory “guidance” should not dictate how banks do business.
Before the 2016 election, bankers told regulators and congressional aides that their banks simply wanted to originate the loans and then sell the risk off to investors, such as insurance companies and mutual funds. Bankers argued that even if the loans were risky, the federally insured banks would not stand to lose if the loans went south because they had sold the products on to others, according to five banking industry executives involved in the discussions.
The biggest opposition to the guidelines was made by a trade association called the Clearing House Association, whose members include JP Morgan Chase, Wells Fargo and Bank of America, those people said. The Clearing House Association last year merged with another entity and formed a group called the Bank Policy Institute. That group’s chief executive, Greg Baer, declined to comment.
Over several months in 2017, a flurry of events helped unravel regulators’ previous efforts.
In March 2017, two months after Trump’s inauguration, Sen. Patrick J. Toomey (R-Pa.) sent a letter to the Government Accountability Office asking for a legal ruling on whether the 2013 guidance should have been classified as a “rule.”
This designation mattered because Congress has the ability to repeal a “rule” with a majority vote, and Republicans in Congress were moving swiftly to nullify multiple regulations with this tactic.
Toomey is one of the Senate’s top voices calling for more banking deregulation, and 10 of his 17 biggest campaign contributors are financial company officials.
In an interview, Toomey said he was not approached by any financial company about the leveraged-lending issue. Instead, he said his aides identified it as a glaring example of the type of regulatory overreach he had long fought to curb.
“It comes, first of all, in the context of a broader effort on my part to diminish the . . . near omnipotence of some regulators and restore legislative authority to where it belongs, which is Congress,” Toomey said.
Less than two months later, Trump replaced Thomas Curry, appointed by President Barack Obama to lead the OCC, with banking attorney Keith Noreika.
In June 2017, Treasury Secretary Steven Mnuchin issued a 149-page report calling for changes to the way financial companies are overseen by the government. Among them, Treasury’s report said banks found the guidance confusing, which was one reason they had cut back on these loans.
Treasury urged the agencies to effectively suspend the guidance and issue it again, this time seeking more feedback from banks. These loans were key to helping the economy grow and extending credit to companies that might not otherwise have access to it, the Treasury report said. Treasury officials met with bankers and others as they prepared to write the report, though it is unclear what their role was in having input into the final language.
In October 2017, the GAO issued a report saying the 2013 “guidance” should have been issued in a more formal way, a position that raised the possibility of invalidating the regulators’ power.
The next month, Rep. Blaine Luetkemeyer (R-Mo.), then-chairman of the House subcommittee on financial institutions and consumer credit, sent a letter to the regulators asking for assurances that they would not be enforcing the leveraged-lending guidance.
A few days later, Noreika told the Wall Street Journal that the leveraged-lending guidelines “shouldn’t be binding on anyone.” Noreika, who has returned to the private sector and advises financial companies, among others, declined to comment.
'The wrath of Khan'
The floodgates were only beginning to open.
Noreika’s replacement at the OCC was Joseph Otting, a financial executive and former colleague of Mnuchin. In early 2018, Otting told an investor conference in Las Vegas that banks, in terms of leveraged loans, “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.”
He remarked on all the tightening that took place after the 2013 guidance came out: “It was like people were afraid to jump over the line without feeling the wrath of Khan from the regulators,” he said, according to a Reuters report at the time.
The comments stunned some regulators at other banking agencies, as they had become concerned watching bankers dive back into the high-risk corporate lending business, according to two people involved in the discussions, who spoke on the condition of anonymity because they were not authorized to reveal internal agency deliberations.
Long, the former top official at the OCC, said he and many of his former colleagues believe that, with the U.S. economy entering its 10th year of growth, it is only a matter of time before a downturn begins and many of these loans unravel. When companies default on their loans, bankers often retrench and won’t lend as freely, worried about extending money to other companies that could also default. This can quickly affect the broader economy, leading to layoffs and bankruptcies, and halting new investment.
“We are in the eighth year of a seven-year credit cycle,” he said. “When things turn, they are going to turn hard.”
'Someone's going to get hurt there'
As regulators scaled back scrutiny, bankers began to binge.
Financial companies issued a total of $1.271 trillion in leveraged loans in 2017 and 2018, 40 percent more than in 2015 and 2016, according to S&P Global Market Intelligence. More than 80 percent of the loans made in 2018 were made with fewer restrictions on the borrower and fewer protections for the lender in the event the loan falls into default.
These loans are often central elements of the leveraged buyouts private equity companies perform when they take over a struggling company at risk of collapse.
In the past few years, household names like J. Crew, PetSmart, Neiman Marcus, Buffalo Wild Wings and Nine West have all been restructured with leveraged loans. There are hundreds of other cases, including energy and health-care companies, many of which received multibillion-dollar loans from a consortium of banks and other lenders.
Asked about the company’s exposure to leverage loans, JPMorgan Chase chief executive Jamie Dimon told analysts in January that banks are much more resilient — and smarter — than they were 10 years ago. He acknowledged that some financial companies, particularly those that are not banks, could lose money during a recession because of these products, but he expected the impact would be contained.
“Someone’s going to get hurt there,” he said.
Bank of America chief executive Brian Moynihan had a similar take in the earnings call for his company that month. He said his company makes a number of these loans but sells them off immediately — an indication that they do not hold any of the risk on their balance sheet.
“We market and move them out, and it’s gone,” he said.
One reason bankers have been able to make so many of these higher-risk loans without regulatory interference is that they sell these products on to outside investors. The loans are packaged into products known as collateralized loan obligations, or CLOs.
The CLO market has surged in the past 10 years, growing from $300 billion at the end of 2008 to $615 billion at the end of 2018, but the quality of these products is worse than it was before the financial crisis, according to the Federal Reserve Bank of Dallas.
Some former regulators have noted an eerie parallel between the subprime mortgage crisis and the leveraged-loan buildup. In the 2000s, banks and other finance companies took risky loans — certain mortgages — and packaged them into products that were sold off to investors. Financial companies also made other exotic instruments, known as collateralized debt obligations, tied to those securities. The products entangled financial companies with one another, allowing weak institutions to pull down stronger institutions when the value of these products cratered.
Today, regulators say they don’t have a firm grip on what the impact will be when the economy weakens or enters a recession.
“We’re doing a lot of work in this area, trying to understand the risk better,” said Bob Phelps, the OCC’s deputy comptroller for supervision risk management. “How this will play out … is really hard to figure out.”
Banking industry expands its influence
The recent reluctance to crack down on leveraged lending is part of a broader regulatory walkback.
Officials at the Fed, which is charged with spotting risks posed by large financial institutions to the financial system and broader economy, announced plans in March to scale back the process they use to monitor the way large banks weather a recession. Officials said banks had made improvements in how they prepared for the next downturn. Lael Brainard, a member of the Fed’s Board of Governors and an Obama-era appointee, was the only Fed official to vote against the move. The others who voted for it were appointed by Trump.
In November, Sen. Elizabeth Warren (D-Mass.) pressed Randal Quarles, the Fed’s vice chairman for bank supervision, on whether regulators were doing enough to address the record levels of leveraged loans. She asked why the 2013 guidance was not being monitored as it had been five years ago.
Quarles said the Fed was more appropriately focused on whether banks posed a risk to the financial system.
“We are monitoring compliance with safety and soundness,” Quarles responded. “We should not monitor compliance with guidance.”
He stressed, however, that the Fed and other regulators were monitoring the risks leveraged loans could pose, though he did not offer any assessments.
“We are actually quite athletically looking at that,” he said, without explaining what he meant.
Having made substantial progress in pushing regulators to soften scrutiny of leveraged loans, the banking industry is continuing to expand its influence.
Last year, partly at the urging of Powell, the White House nominated economist and financial-regulation expert Nellie Liang to the central bank’s Board of Governors.
Her nomination from the White House was exceptional, in that she does not have a banking background and previously worked at the Fed to fine-tune oversight of financial companies. She formerly directed the Federal Reserve’s Office of Financial Stability, one of its most powerful components.
Banking industry lobbyists whipped up opposition to Liang, persuading some Republicans on the Senate Banking Committee to block her confirmation, according to five people involved in the process. In January, she announced she was withdrawing from consideration after it became clear she could not win Senate confirmation.
Trump then went in a much different direction and announced his intent to nominate two big political supporters, Herman Cain and Stephen Moore, to open seats at the Fed. Neither has commented on leveraged lending, but both are big proponents of stripping back regulations and have called for immediate steps to make the economy grow even faster.