The total of corporate leveraged loans has hit $1.6

trillion globally, far exceeding the records set prior to the

crisis of 2008.

The loans ballooned after the Trump Administration

reversed a stricter Obama-era policy discouraging high

leverage.

Now, leverage is increasing, while underlying covenant

quality is decreasing.

The US Federal Reserve, the Bank of England and the

Reserve Bank of Australia have all sounded the alarm over the

loans.

It is only October and already the UK economy has set a dubious

new record for the year: Leveraged loans to British

companies have hit about £40 billion ($52 billion), according to

the Bank of England. Prior to the financial crisis, new

issuances of such loans only totalled £30 billion ($39 billion).

Britain’s stock of risky corporate debt is part of a trend.

Globally, leveraged loans have hit $1.6 trillion, according

to Institute of International Finance:

Central banks are starting to worry that the corporate world may

have taken on too much debt, and that the stock of risky debt

overhanging the global economy might start to behave the way

sub-prime mortgages did prior to 2008.



The Bank of England recently suggested that leveraged loans might

become a bigger problem than sub-prime mortgages were: “The

Committee is concerned by the rapid growth of leveraged lending,

including to UK businesses,” the BOE’s Financial Policy Committee

said recently. “The global leveraged loan market is larger than –

and growing as quickly as – the US subprime mortgage market was

in 2006.”



The Reserve Bank of Australia has the same concerns.

The amount of “leverage” — the multiples in debt that companies

are getting into — is growing, too.

“If you look at leverage ratios, they are getting riskier because

they are getting higher. Obviously, as a company takes on more

debt it’s a riskier proposition than a company that takes on less

debt,” said Marina Lukatsky, a director at the Leveraged

Commentary & Data unit of S&P Global Market

Intelligence, in a conversation with Business Insider.

In 2013, the “issuance” of new leveraged loans peaked at $607

billion. But

regulators under President Obama frowned publically upon excess

leverage, and the market declined through 2015 to a low of

$423 billion. After President Trump took office, however,



his appointees told the banking sector that they were going to be

less strict about loan leverage. In 2017, new loan issuance

went back up, to $650 billion — a new record.

The total of new leveraged loan issued last year exceeded

pre-crisis levels by about $100 billion



Put simply,

leveraged loans are given to troubled companies who can’t get

access to cheaper credit via a normal loan from a bank or by

raising an investment-grade corporate bond. The “leverage” comes

from private equity (PE) groups, who invest their own money in

return for a chunk of equity in the company, in combination with

the loan. The rest of the funding may be provided by banks.

The loans are then bundled and sold on private markets in the

form of collateral loan obligations — bundles of debt that can be

bought and sold like mortgages. The PE groups are hoping that the

equity and debt investments they make are enough to turn the

companies around. When that happens they can sell their stakes at

a premium.

Investors have poured money into leveraged loan products because

the companies who take them are required to pay higher rates of

interest than they would get by holding government bonds.

Most of the loans are being made in the US.

Business Insider asked the Leveraged Commentary & Data unit

of S&P Global Market Intelligence to pull its data on

leveraged loans so we could get a clear view of just how big a

market it has become. The numbers show the loans are becoming

bigger — and riskier — over time.

Here is the total volume of new leveraged loan issuance in US

dollars. Last year was a record, exceeding the pre-crisis level

by about $100 billion. And 2018 will be another strong year:

Transaction size — the total of debt and equity in leveraged loan

deals — is also approaching a new peak, although it remains below

the 2007 record:

Perhaps most worryingly, the debt-to-EBITDA ratio of the average

loan is once again heading toward a multiple of six, per LCD,

S&P Global Market Intelligence said.

The ratio measures the amount of debt taken on by a company in

comparison to its earnings before interest, taxes, depreciation

and amortization. The higher the multiple, the bigger the loan in

relation to the company’s ability to pay it off:

‘No, no, no, no, no’



The “6x” multiple is significant. In 2013, under the Obama

Administration, regulators frowned upon leveraged loans issued at

six times earnings. Between 2013 and 2016, leveraged loan volume

declined, and so did debt multiples.

But Trump Administration officials have been more relaxed.

Issuance went up. This year, more leveraged loans were issued at

over 6x.

Joseph Otting, the Comptroller of the Currency, told

a financial conference in Las Vegas in February that

banks could proceed beyond the old 6x level as long as they felt

it was sound. “When (the idea of the) guidance came out — it

was like people were afraid to jump over the line without feeling

the wrath of Khan from the regulators,”

Otting said .

“But you 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.”

Later, in May, he reiterated, “I

think it was always intended to be guidance,” rather than a

cast-iron rule

That statement was in stark contrast to the one made

by Federal Reserve official Todd Vermilyea in 2014, under

Obama. In a speech to bankers on whether he wanted to see

corporate loans go over six times earnings, Vermilyea said:

“No,

no, no, no, no.”

The 6x line is still an important concept in judging whether a

company has taken on too much leverage, according to

S&P’s Lukatsky.

“The leveraged lending guidelines that were issued in 2013, they

stated that if a company has a leverage issue of six times or

higher, it basically raises concerns with the regulators,”

Lukatsky told Business Insider.

“Six times became a line, if you are above six times you are

considered riskier to the regulator.”

“It’s kind of like you’re either above or below that line,”

she said. “Now we’re at 5.8, so we’re almost there, so

it is notable.”

‘Highly leveraged deals account for a growing share of new

leveraged loan issuance and have surpassed pre-crisis highs’



The International Monetary Fund (IMF) is also worried that the

number of loans over 6x are going up as a percentage of the

whole.

“Notably, highly leveraged deals account for a growing share of

new leveraged loan issuance and have surpassed pre-crisis highs,”



the IMF said recently.

“Bank balance sheets have strengthened … but nonbank financial

entities have increased their leverage, including through the use

of derivatives. In the euro area, leverage in the corporate and

sovereign sectors remain elevated.”

This chart from the IMF shows the percentage of deals at or near

6X leverage rising over time:

A company’s creditworthiness is measured by its “interest

coverage ratio.” The ratio measures the amount of interest a

company must pay compared to its earnings. The closer a company

gets to coverage of just one — in which a company’s interest

payments are equivalent to 100% of its profits — the worse the

coverage ratio looks.

Companies’ ability to cover their interest payments is better now

than during the crisis, although it has recently declined,

according to LCD/S&P Global Market Intelligence. Since 2014,

the average interest coverage ratio has declined by 17%, from a

high of 3.37 to 2.79 this year:

As interest rates rise, companies’ ability to cover their debts

declines



The potential worry is that the recent decline is a sign of

emerging fragility among the companies paying those debts.

Credit ratings agencies — like Standard & Poor’s or Moody’s

or Fitch — may downgrade the quality of that debt or downgrade

the creditworthiness of the companies trying to pay it. The

crucial level is “BBB,” or “investment grade,” which signals a

minimum level of quality. Once companies, or their debt, fall

below BBB, they enter “junk” or “speculative” status. Many

investors have a policy to automatically sell debt with that

rating.

So as interest rates rise, and companies’ ability to cover their

debts declines, the chance of more leveraged loans falling below

BBB goes up — and that could set off a downward spiral of

automatic selling.

Interest on leveraged loans is typically based on a floating

rate, such as a “spread” above the London Interbank Offered Rate

(LIBOR). If LIBOR goes up, their interest burden goes up. Until

recently, interest has been low — both the BOE and the US Federal

Reserve have held interest rates near zero for years.

Spreads have been small, too. Those lowered costs have tempted

more companies into taking the loans, according to the IMF.

“The share of lower-rated companies has increased because

compressed spreads have encouraged the buildup of leverage,”



its most recent global financial stability report said.

80% of leveraged loans are now ‘covenant-lite’



At the same time, the restrictions placed on companies taking the

loans have become more relaxed. Usually, when a company takes a

loan, it comes with a “covenant” that requires the company to

maintain certain financial standards, such as ensuring that its

earnings remain above a specific level in comparison to its debt.

But covenants have been largely abandoned in the leverage loan

market. Today, almost 80% of leveraged loans are “covenant-lite,”

according to the Bank of England.

That’s another sign of increasing risk, S&P’s Lukatsky told

Business Insider. “The share of deals that are lacking typical

covenant protection … is also increasing, so there is a

definite a level of risk here,” she said.

“Good or bad is kind of a relative term but as far as risk is

concerned, at least based on these metrics, definitely.”

Anton Pil, the head of JPMorgan’s $100 billion alternative

investment arm, gave a presentation in London earlier this month

that also worried about “covenant-lite” debt. “If you look

back in 2007, we were worried about cov-lite debt in 2007, and

that number was about a quarter of the market,”

Pil said.

“Today, it’s almost 80% … If you want to worry about something in

the next two or three years, this is it.”

‘Leveraged loans are typically sold to non-bank investors …

whose ability to sustain losses without materially impacting

financing conditions is uncertain’



The Bank of International Settlements — often referred to as the

central banks’ bank — put this $1.6 trillion debt pile in

context. The total of leveraged loans plus high-yield bonds

(both are types of high-risk junk debt) on the market has reached

$2.15 trillion, BIS says.

That is big enough to be a systemic threat to the stability of

the global finance system,

according to the most recent minutes from the US Federal Open

Market Committee. The Fed did not detail its concerns, saying

only: “Some participants [on the committee] commented about the

continued growth in leveraged loans, the loosening of terms and

standards on these loans, or the growth of this activity in the

nonbank sector as reasons to remain mindful of vulnerabilities

and possible risks to financial stability.”

So who gets hurt if the boom collapses?

The Fed did not say, and the Bank of England admits it is not

clear. But it won’t be the banks. The BoE said all UK banks were

now robust enough to withstand a 2008-level crisis. And, as the

Fed noted in its commentary, it believes the risk is located in

the “non-bank sector”.

That is because banks have long since sold on the loans to less

robust customers. The BOE doesn’t know if those investors are

strong enough to withstand their potential losses: “Leveraged

loans are typically sold to non-bank investors (including to

collateralised loan obligation funds), whose ability to sustain

losses without materially impacting financing conditions is

uncertain,”

it’s financial policy committee said in early October.