NEW YORK/ST. LOUIS (Reuters) - Bankers, executives and investors are warning Federal Reserve officials behind closed doors that record leveraged lending to companies from lightly-regulated corners of Wall Street could make any economic downturn harder to manage.

FILE PHOTO: The Federal Reserve building is pictured in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie/File Photo/File Photo/File Photo/File Photo

With the second-longest U.S. expansion in its advanced stages, the worry is that a key part of the credit market could be particularly vulnerable to a slowdown, as highly-indebted companies face a greater risk of default.

Some of those involved in the debate who spoke to Reuters expressed frustration that the Fed is not taking the risk seriously enough.

“There is a sense at the Fed that it needs to watch this area, leveraged credit, but it’s still in the infancy and it’s unclear how far will it go,” said an economist familiar with the Fed’s efforts.

In a worst-case scenario that would faintly echo the financial crisis a decade ago, the defaults could worsen any downturn by destabilizing big non-bank lenders, such as private equity firms and hedge funds, and hitting employment across U.S. industries. Leveraged loans are typically made to already indebted firms with low credit ratings, and the concern is that the loans would be difficult to either collect or resell in a downturn, putting both the borrower and lender at risk.

“Just the sheer size of market-based credit intermediation is very different (from years past) and we don’t quite know how that is going to behave in a downturn,” Tobias Adrian, director of the monetary and capital markets department at the International Monetary Fund, said in an interview.

Few believe leveraged loans today would set off a crisis similar to the one triggered by a wave of defaults in the U.S. subprime mortgage market in 2008, since they are focused on a smaller part of the economy than the sprawling housing market.

They do, however, risk handcuffing companies and lenders trying to react to a downturn, possibly making it more painful.

The Fed on Wednesday is due to publish for the first time a new semiannual report on financial stability, analyzing conditions in different corners of the financial system including leveraged lending.

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The central bank itself may have contributed to the ballooning $1.12-trillion U.S. leveraged loan market by holding interest rates near zero for seven years in the wake of the recession to encourage lending and investment.

By comparison, collateralized debt obligations, or CDOs, which spread toxic housing debt through the world’s financial system, was worth some $61 trillion globally in 2007, according to the Bank for International Settlements.

The total leveraged loan market is now about double what it was in 2008, and it has grown 17 percent so far this year, based on the S&P/LSTA Leveraged Loan Index.

A record 59 percent of those "junk" loans are rated B+ or worse, according to S&P Global. "Risks attributable from this debt binge are significant," it said last month. (Graphic: tmsnrt.rs/2DAQPl4)

According to Fed policymakers who spoke to Reuters, those who have spoken to central bankers, and minutes of recent meetings of the Federal Advisory Council, private discussions increasingly center on the growth of leveraged credit and the risk it poses to overall financial stability. The council is made of bankers appointed from the Fed’s 12 regional districts to consult with the central bank.

For example, some regional Fed presidents have asked corporate chief executives whether they are seeing leveraged loans use debt structures that would appear particularly dangerous in a credit crunch. Loans that have to be renewed and refunded frequently, for example, might belong in that category.

In Washington, one banker on the advisory council told Fed governors that non-regulated lenders were “driving aggressive structures” and cutting out heavily-regulated banks, according to the minutes of a September advisory council meeting.

‘SO EXTREME’

Scott Minerd, managing partner at Guggenheim Partners, said President John Williams and some of his colleagues at the New York Fed were “taken aback” when he told an advisory meeting that he did not think the Fed could safely avoid a messy recession in the face of the credit build-up and other risks.

“Because it is now so extreme, any attempt to rein in credit expansion is going to ultimately blow up,” Minerd said at the Reuters Global Investment 2019 Outlook Summit this month.

Credit spreads - or the difference between government and corporate borrowing costs - have already widened to a two-year high for both investment-grade and high-yield debt. In what could be a taste of things to come, General Electric Co's GE.N bonds tumbled this month as it scrambled to raise cash. [nL4N1XO4MT]

Minerd said the Fed and other regulators did not yet seriously consider a scenario in which credit spreads would rise much further prompting regulators to force liquidations at insurers and other firms that had bought so-called collateralized loan obligations, or CLOs. Like the CDOs behind the housing crisis, CLOs bundle corporate loans into a single security.

“They don’t really have a good handle on where this risk lives,” he said.

For example, one question where regulators and bankers have little clarity is who supplies the money that non-bank lenders are pouring into leveraged loans.

The central bank has been paying more attention to elevated leveraged loans this year, with Fed Chair Jerome Powell telling a public forum earlier this month, “There is some significant corporate borrowing and we have our eyes on that.”

But Powell stressed that risks were “pretty moderate” when viewed through a broader lens that includes asset prices, bank leverage and household and business borrowing.

St. Louis Fed President James Bullard echoed that sentiment this week. Bullard told Reuters in an interview the bursting of the tech bubble at the turn of the century was a more fitting point of reference for corporate debt markets today, rather than the housing market around 2007, because it was a case where individual investors were at risk but not the economy as whole.

“The first one blew up without major macroeconomic consequences... For the most part investors licked their wounds and went home. That is a case where you let markets work,” Bullard said.