Fed warns over leveraged lending as banks chase riskier deals

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The Federal Reserve is getting more concerned about risks from the leveraged loan market, with a key official saying it's now taking a "closer look" at whether Wall Street banks are chasing deals without adequately protecting themselves against losses.

"There may be material loosening of terms and weaknesses in risk management" in the $1.3 trillion market, Todd Vermilyea, the Fed's head of risk surveillance and data, said Wednesday at an industry conference in New York. Vermilyea's remarks were spurred by emerging trends that he said could threaten the safety and soundness of the biggest banks.

After regulators appointed by President Donald Trump said they would take a lighter touch with banks, lenders began testing the limits of what federal watchdogs would tolerate in providing financing for heavily indebted companies. Morgan Stanley, Goldman Sachs Group Inc. and Credit Suisse Group AG are among firms that have recently participated in deals that exceeded what the Fed previously deemed appropriate.

In 2013, regulators issued tough industry guidance for banks. But when the Government Accountability Office determined last year that the Fed and Office of the Comptroller of the Currency had overstepped their authority, the regulators agreed they would stop enforcing the guidance.

Comptroller of the Currency Joseph Otting, the top regulator of national banks, said last week that the industry has "really kind of stayed on the rails," mostly remaining within "relatively healthy" measures of leverage. The riskiest leveraged loans are being done by private-equity firms, he said. Vermilyea's remarks indicate Otting's counterparts at the Fed aren't as comfortable, and recent lending statistics show a shifting landscape.

Last month, 14 regulated banks along with KKR Capital Markets underwrote $6.7 billion of loans and bonds in the buyout of Envision Healthcare Corp., one of the largest deals of the year. That represented a multiple of 6.9 times debt to earnings. The 2013 guidance had imposed extra regulatory scrutiny when ratios rose above 6 times earnings.

Vermilyea highlighted a few areas of concern Wednesday, including the growth in so-called covenant-lite loans, which offer fewer safeguards for lenders. He also flagged the increased use of "collateral stripping," in which borrowers move collateral out of reach of creditors. The Fed is examining how banks are managing risks from these practices, Vermilyea said.

Bloomberg News