By David Lerner & Lee Shaiman
September 13, 2019 at 5:00 am ET
After 10 years of economic recovery following the global financial crisis, many lawmakers and regulators in Washington, D.C. have grown fearful that a dangerous new bubble is hiding in plain sight. This has led some politicians to mistakenly compare America’s $1.2 trillion leveraged loan market to the pre-crisis subprime mortgage morass.
The reality is that aside from a few surface-level similarities, the leveraged loan market of today and the subprime mortgage market of yesteryear are fundamentally different. Policymakers need to come to terms with this before overly aggressive rhetoric begins to stifle the flow of capital to countless companies across the country.
For starters, it must be recognized that leveraged lending in the U.S. has grown at a measured pace over the past decade, particularly in comparison to the corporate bond market. Data from Wells Fargo Securities shows that while the leveraged loan market has grown by 107% since 2007, the investment-grade bonds market has grown by 156%. Lenders and investors purchasing loans have not exhibited the type of reckless behavior that many mortgage originators pioneered in the lead-up to the 2008 downturn, which is one reason why the market remains liquid and stable today.
The health of the leveraged loan market right now is evidenced by a default rate that sits just above 1.25%, a figure well below the long-term average. Additionally, net leverage of senior secured loans is below peak levels while interest coverage ratios remain very high, indicating corporate borrowers are well-positioned to service debt.
Another important point is that the alarm bells triggered over “covenant lite” issuances – which are loans that have less stringent terms – have been ringing far too loudly. Although senior secured lenders are less likely to have certain maintenance covenants, we believe that the impact on loan default rates is likely to remain mild owing to other significant incurrence covenant protections. Also keep in mind that leveraged loans are senior within corporate capital structures and are secured obligations, so these loans typically hold the strongest claims on borrowers’ assets in the event of a bankruptcy or default. These protections have historically resulted in high recoveries
Lastly, it must not be overlooked that most leveraged loans are not held on banks’ balance sheets, because collateralized loan obligations (CLOs) are the primary buyers. These CLOs, which are actively managed by SEC-regulated investment managers and distinct from crisis-era collateralized debt obligations (CDOs), are governed by sound practices and clear limitations designed to maintain strong loan quality and diversification.
CLOs play a truly valuable role in keeping the corporate loan markets liquid and flowing. Because they are long-term holders that are rarely forced to sell, their existence insulates borrowers and lenders when the markets become more volatile over the course of a full cycle. The Bank of England’s latest Financial Stability Report highlighted how current CLO structures are much more robust compared to pre-crisis structures.
In sum, any objective analysis of today’s corporate loan market should lead members of Congress and the administration to conclude that leveraged lending is unlikely to spur a “subprime 2.0” situation.
Top central bankers, including current Federal Reserve Chairman Jerome Powell and former Chairwoman Janet Yellen, have recently acknowledged that leveraged loans do not pose systemic risk to the American economy. To the contrary, many well-known companies that produce valuable goods and quality jobs rely on these loans. It was therefore particularly disappointing that a June congressional hearing focused on the market included many inaccurate comparisons of CLOs to the pre-crisis CDOs that held toxic subprime mortgage debt.
As central banks warn of risks to global economic growth, we implore elected leaders to embrace the reality of this marketplace so that it can continue to play an important role in the broader economy. Drawing on memories of the Great Recession to miscast leveraged loans undermines the type of inclusive, growth-oriented economic agenda that policymakers on both sides of the aisle can agree on.
David Lerner is a Senior Portfolio Manager and the Head of Senior Secured Loans and Structured Credit at Shenkman Capital Management.
Lee Shaiman is the Executive Director of the Loan Syndications and Trading Association, which is the advocacy voice for the corporate loan market.
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