Like most people, you probably assume that the level of lending done by banks at any moment is largely driven by how much demand there is from borrowers. But in the world of modern finance, that’s only part of the story. For just as important is the level of demand from investors — pension funds, hedge funds, mutual funds, sovereign wealth funds and insurance companies — to buy the loans that banks make. Indeed, there are times when there’s so much demand for loans from investors and the profit from selling them is so lucrative that bankers are only too happy to go out and make bigger and riskier loans than they would if they were keeping them on their own books.
That was the situation back in 2006 when investors were so keen to own “mortgage-backed securities” that Wall Street was begging lenders for more and more “product.” You know how that turned out.
Now it is happening again, as investors and money managers scramble to buy floating-rate debt — debt offering interest payments that will increase as global interest rates rise, as they are expected to over the next few years. A big new source of floating-rate credit is the market for “leveraged loans” — loans to highly indebted businesses — that are packaged into securities known as “collateralized loan obligations,” or CLOs. Because the market seems to have an insatiable appetite for CLOs, leveraged lending and CLO issuance through the first half of the year are already up 38 percent over last year’s near-record levels.
Credit-rating companies such as Standard & Poor’s and Moody’s have recently warned that this surge in corporate borrowing and lending has led to a noticeable decline in the quality of the loans. The borrowers have lower credit ratings. The loans contain fewer of the standard conditions that are meant to protect lenders. And the rating companies calculate that lenders should expect to recover less of their money if the borrowers default or go into bankruptcy.
For the most part, however, these warnings have gone unheeded. Although some sophisticated investors have begun to pull back from the CLO market, they have been replaced by retail investors seeking higher yields who have flocked to mutual funds and exchange-traded funds that specialize in CLO debt.
Many of the borrowers in the leveraged loan market are midsize companies that most people have never heard of. But some are large companies that you would recognize — Dell, Tesla, Uber, BMC Software, Japan’s SoftBank and office-sharing company WeWork. What they all have in common is that they already have so much debt that their credit rating is below investment grade, or “junk” as it is known on Wall Street. In effect, they are the “subprime” borrowers in the corporate loan market.
It is no coincidence that the decline in loan quality has occurred as there’s been a shift in who is doing the lending. Back in 2013, 70 percent of the loans were made by major banks whose lending is closely scrutinized by government bank regulators. That figure is now down to 54 percent, according to Bloomberg, as hedge funds, private-equity firms, insurance companies and non-regulated lenders have entered the market in a big way. This shift in market share away from banks mirrors what happened to mortgage lending in the run-up to the 2008 crash, when competition from unregulated lenders led banks to lower lending standards in an effort to maintain their market share.
There’s also been a shift in how the loans are being used. Some of the debt is being used, as it always has been, to finance expansion or refinance old debt. But more recently, a growing portion of leveraged lending has been used to buy back stock, pay special dividends to private-equity firms cashing out of their investments or to finance richly priced mergers and acquisitions, which are now running at a pace that exceeds the bubbles of 2000 and 2007. In other words, it has been used to reward investors rather than grow the business.
The mergers and acquisitions are particularly troublesome. According to Covenant Review, a debt analyst, the amount of debt used to finance these takeover deals has grown significantly, from 6.4 times cash flow in 2015 to 7.7 times cash flow in the first quarter of this year. Moreover, analysts warn that as much as 30 percent of that expected cash flow might never materialize because of overly rosy assumptions about cost savings and revenue growth. A slowdown in the economy or a rise in interest rates could very well put those companies in a cash squeeze and result in losses for CLO investors.
As with mortgage-backed securities, one attractive feature of CLOs is that they are sliced into what are known as tranches. There is the high-risk “equity” tranche whose holders currently earn returns as high as 15 percent a year for assuming the risk of being the first among the investors to suffer losses if companies in the pool cannot meet interest payments or repay their loans. There are the middle, or “mezzanine” tranches, whose holders earn mid- to high-single-digit returns if all goes well and suffer losses only when the equity holders lose their entire investment. And there is the lowest-risk “senior” tranche that currently offers annual returns of one percentage point above Treasury yields, whose holders would lose money only in the highly unlikely event that the other two tranches are wiped out.
It is through such alchemy that the wizards of structured finance are able to take a package of $400 million of loans rated at BBB- or below (junk) and generate $240 million worth of AAA-rated securities, along with $160 million of lower-rated instruments — a tranche to satisfy every risk appetite.
Although financial regulators have taken passing notice of the increased volume and declining quality of corporate credit, they haven’t done much to discourage it — just the opposite, in fact.
Earlier this year, after complaints from banks and dealmakers reached sympathetic ears in the Trump administration, the newly installed chairman of the Federal Reserve and the Comptroller of the Currency Office declared that previous “guidance” against lending to companies whose debt exceeded six times their annual cash flow should not be taken as a hard and fast rule.
Regulators later explained that the announcement was not meant to lower lending standards but rather to emphasize that multiple factors would be used by bank examiners in assessing loans. More broadly, their view is that because banks are now so much better capitalized, with less leveraged and less reliance on short-term funding, they will be able to survive a serious market correction, as demonstrated by recent “stress tests” in which their exposure to leveraged loans was factored in.
Whether intended or not, however, the market read the regulators’ announcement not only as a green light to the banks to step up their leveraged lending but also as an indication that regulators would be more responsive to industry pressure than during the Obama years.
The CLO market got an even bigger boost this year when an appeals court in Washington struck down a regulation issued under the Dodd-Frank financial regulation law that required all securitizers — the firms that bundle loans of any kind and sell pieces of the packages to investors — to retain 5 percent of a deal. The regulation’s rationale was that if the securitizers had “skin in the game,” they wouldn’t have an incentive to make or buy questionable loans and peddle them to unsuspecting investors. For Dodd-Frank’s authors, this was a central feature of the architecture of financial reform.
When the risk retention rules were finally announced, however, the association representing independent CLO managers — those not associated with big banks — sued to block it, arguing the law did not apply to them because they never take ownership of the loans, so there is nothing for them to “retain.” Instead, these managers raise money from investors through an independent, legal entity known as a special purpose vehicle and then direct the SPV to use that money to buy the loans on the open market. A district judge saw through the ruse and dismissed the suit, but in February, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit bought the industry argument hook, line and sinker.
The appeals court opinion is a model of legal and etymological hairsplitting by activist, conservative judges who were clearly looking for a way to ignore the explicit intent of Congress, which was to make risk retention a feature of all loan-backed securities, no matter who made the original loan.
In fact, the CLO managers had asked the House Financial Services Committee to include a specific exemption for them in the law, citing the financial burden it would place on smaller securitizers. They also argued that the standard CLO fee structure, which provided bonus payments if investors were paid in full, was the equivalent of their having “skin in the game.” The legislators, however, were not receptive to those arguments.
“The basic idea was to cover all securitizations, so we used very broad language,” Lawranne Stewart, then assistant chief counsel to the committee, recalled. “In fact, the language in the bill generally was so broad that we were criticized for overreaching. . . . We told [the CLO managers] that we would leave it to the regulators to deal with the question of who did and did not deserve an exception.”
Regulators, however, were also reluctant to create an exception. As they warned the appeals court in their briefs, if independent CLO managers were exempted from risk retention, it would create a giant loophole for any managers using the same method and structure to securitize any type of loans. Those who didn’t would be at a serious competitive disadvantage.
Although none of the three judges had spent a day working on Wall Street, they nonetheless dismissed the warnings of agency experts and in their opinion “provided a road map for securitizers of all sorts to avoid risk retention,” according to Michael Barr, a professor of law and public policy at the University of Michigan who served as point man on the financial reform effort for the Treasury in the Obama administration. As a result, Barr said, we “have now re-created the condition that led to the last crisis by making it easier to aggregate loans that are not good for investors.”
The three judges who signed on to that opinion were all appointed by Republican presidents, all have a long track record of skepticism toward regulation and regulators, and all have a long association with the conservative Federalist Society. Only one of them, however — Brett M. Kavanaugh — was just nominated by President Trump to be a justice of the Supreme Court.