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Regional Commercial Banks And The Problem Of Leveraged Loans

by: John M. Mason

A number of analysts are expressing concern about the performance of leveraged loans and what this might mean for the profits of regional commercial banks.

The concern is not with a buildup of systemic risk, but with the possibility that these banks could suffer a hit to profits if conditions continue.

This situation has arisen because of past Federal Reserve ease, and it appears the future outcome will be related to the coming actions of the Fed.

Today we discuss another round of stories from the financial world that tie together two major factors impacting the banking system right now.

The two major factors I am talking about have to do with the amount of money that has been…and still is…available to borrowers and the role that the monetary policy of the Federal Reserve System has played…and is still playing…in creating and sustaining such a situation.

First of all, there is lots and lots of money available in the world today.

The specific area of the financial market we are talking about today, however, is the market for leveraged loans.

Leveraged loans are high-interest rate, often floating-rate borrowing, by companies with shakier credit. These loans are typically secured with a lien on the company’s assets and are generally senior to the company’s other debt. A leveraged loan is structured, arranged and administered by at least one commercial or investment bank. These institutions are called arrangers and subsequently may sell the loan, in a process known as syndication, to other banks or investors to lower the risk to lending institutions.

Right now, some people are getting a little anxious about the state of this area of the financial scene.

For example, Robert Armstrong writes in the Financial Times:

A senior lending executive at a famously conservative US bank recently offered me a warning. Look at almost any regional bank across America, he said. If the commercial lending portfolio is growing much faster than the market, ‘they are buying paper.’

"What he meant was that those burgeoning portfolios had been fattened by loans that the banks themselves did not originate with their own customers. ‘Paper’ instead means slices of big loans — from the tens of millions up to the billions — that are cut into various tranches, according to the level of risk, and syndicated out to banks. Some of these fall into the category of leveraged loans, which are chunks of debt from highly indebted companies that have normally been bought out by a competitor or a private equity firm.”

Bankers will tell you that while they help to raise big syndicated loan deals, or lend money to debt managers to help them put credit funds together, or underwrite collateralized loan obligations, they move most of the risk briskly off their own balance sheets.

Regulators, for their part, do not see leveraged loans as a risk to the banking system as a whole although they will agree that the banks have some ‘backdoor exposure’ to leveraged loans but it does not rise to the level of a systemic threat.

Since 2007, regional banks have built their share of leveraged loans from almost nothing to about 10 percent of the total of the loans outstanding.

Note that we are talking about regional banks…and not the largest banks in the US.

Here is where the actions of the Federal Reserve are brought into the picture. The Fed’s three rounds of quantitative easing, we are told, “crammed” banks with cash, which naturally, they were very willing to put to use. And, among the borrowing companies, the ultra-low interest rates that resulted gave them a strong incentive to borrow.

But, it is still the case, that even in the absence of systemic risk, considerable damage can be done to individual bank profits if they hold the paper of companies that turn out to be over-levered when the economy slows.

Mr. Armstrong mentions that, because of this, provisions for commercial loan losses have already started to rise in the last two quarters after declining for many years. He adds that Saul Martinez, an analyst at UBS, predicts that this trend could get sharply worse in the second half of this year.”

And, why the concern about this possibility at this time?

Funds that specialize in buying junk-rated corporate loans have recorded net outflows for 33 consecutive weeks, a record streak that highlights the diminished appeal of floating-rate debt at a time when the Federal Reserve is widely expected to start cutting interest rates.

So-called leveraged loan funds recorded a net outflow of $754 million for the week ended July 3, according to Lipper. That extended a streak that began in late November and pushed it beyond a previous 32-week stretch of outflows that spanned from mid-2015 to early 2016.

Before the streak of outflows, which has drained $31.8 billion from the funds, investors had poured a net $10.5 billion into the funds in 2018, largely reflecting bets at the time that the Fed would continue to tighten monetary policy.

So, here is an area that could really face massive problems depending upon what the Federal Reserve does.

Outflows from loan funds could create a drag on the demand for leveraged loans, which are the preferred method of borrowing for many businesses because they are easier to quickly pay down or refinance than bonds.

In recent months, some more challenged businesses have been forced to sell loans at larger-than-expected discounts and interest rates, a sign some loan buyers are becoming more discerning with less funds at their disposal.

And, this is a situation that has arisen because of the Fed’s own actions. Monetary ease created an environment where these leveraged loans grew to an important size. Now, the situation has become one where Federal Reserve actions, could create a real balance sheet problem.

However, there is widespread belief among investors that the Fed will help sustain the U.S. economic expansion with at least one interest-rate cut this year. This will support the leveraged loan market.

More and more we are getting the idea that there is a lot more is riding upon the decisions of the officials at the Federal Reserve than maybe we earlier thought.

In other words, the years of government created credit inflation has produced an environment in which sectors of the financial markets that have invented their own sensitivities are now faced with conditions in which greater volatilities might be obtained through monetary and fiscal policies that, at an earlier time, would have been pretty mild.

The several market situations that I have been writing about over the past week or so just highlight the challenges that have been introduced into markets and into Federal Reserve policy making.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.