WASHINGTON — The quality of syndicated credits took a step backward last year as underwriting of highly leveraged borrowers weakened, regulators said Thursday.

The 2013 Shared National Credits report said loans exceeding $20 million that are shared by at least three institutions had a higher incidence of regulatory criticism than in the 2012 review, snapping a three-year streak of improved credit quality in the SNC program, even though total volume continued to increase. Criticized assets rose more than 2% to $302 billion, while the proportion of such assets that were "criticized" was basically unchanged from last year.

"Asset quality improvement experienced during the past three SNC cycles stalled in 2013. This is particularly troubling given the current economic environment and low interest rates," according to the report, which was authored by the Federal Deposit Insurance Corp., Federal Reserve Board and Office of the Comptroller of the Currency.

The sudden deterioration was blamed largely on SNC loan commitments to corporate borrowers that are leveraged above industry norms. In a targeted review of such leveraged assets, the regulators found "material widespread weaknesses in underwriting," the report said. Leverage for borrowers was "excessive," while there was an "inability to amortize debt over a reasonable period, and … meaningful financial covenants" were lacking. The rate of leveraged assets that were "criticized" totaled 42%, compared with 10% of the overall SNC portfolio.

"Other weak characteristics observed include minimal equity and minimal demonstration of deleveraging capacity," the report said.

The three agencies reiterated guidance they released in March urging banks to strengthen risk management of loans to highly leveraged borrowers. Among other things, the guidelines said institutions should independently evaluate all loan participations, which include SNCs.

"Poorly underwritten or low quality leveraged loans, including those that are pooled with other loans or participated with other institutions, may generate risks for the financial system," the report released Thursday said.

Although the higher frequency of troubled syndicated loans was cause for concern in the report, institutions that pool oversized corporate loans reported that demand continues to move upward. Outstanding SNC obligations increased 9.6% to $1.36 trillion, while total SNC commitments in the portfolio increased 7.8% from the previous review to $3.01 trillion. (The report was compiled from financial data as of yearend 2012 and March 31 of this year.)

With the steady volume of loans, the overall percentage of SNC assets that were criticized — meaning they fall under classifications of "special mention," "substandard," "doubtful," or "loss" — fell by one percentage point compared with the previous report. Other positives included improvements in the performance of loans to certain sectors, including commercial real estate. To assess quality of the portfolio, the regulators focused their analysis on $800 billion of the $3.01 trillion in total commitments, with the sample weighted toward criticized assets. Over half of the targeted review was made up of leveraged commitments.

"Borrowers in some segments were assigned improved regulatory ratings due to improved operating performance," the report said. "In particular, criticized credits in the commercial real estate market showed marked improvement."

But the increased volume also included leveraged loans that the agencies said were responsible for keeping the rate of criticized SNC assets stagnant. The report said that if leveraged loans were taken out of the equation, the rate of SNC loans considered "criticized" would have fallen to "a relatively benign" 3.1%. Highly-leveraged loans accounted for 75% of all "criticized" SNC assets.

"While leveraged lending activity declined after the most recent financial crisis, volumes have since increased significantly," the review said.

Observers said the report is another sign that regulators will continue to target loans to borrowers that rely too heavily on their outstanding debt.

"Regulators are very attuned to the risks in this type of lending and my sense is they're going to work hard to ensure that lenders tighten up underwriting and have plenty of capital behind these loans," said Mark Zandi, chief economist of Moody's Analytics. "There is a banking adage that if it's growing like a weed, it's a good chance that it's a weed. It does not mean it is definitely a weed, but the benefit of applying that adage is it helps direct where regulators should focus."

Yet there were other positives in the report as well. Within the share of criticized loans, there were lower levels of the most severe ratings. Assets classified as "doubtful" decreased by over half to $14 billion, although those classified as " loss" increased from $5 billion to $8 billion. Loans rated as either "doubtful" or "loss" made up 0.7% of the portfolio, compared with 1.2% in the prior report.

How assets were distributed among U.S. banks, foreign bank organizations and nonbanks was mostly unchanged from the previous report. U.S. banking companies owned 44% of the portfolio, compared with 36% for FBOs and 20% for nonbanks. But the review said nonbanks continue to hold a disproportionate share of riskier, highly-leveraged assets; they own 67% of all the loans classified as "substandard," "doubtful" or "loss."

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