Leveraged loans take center stage in upcoming stress tests

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Leveraged lending is the boogeyman lurking in the latest round of stress testing for large banks.

The leveraged loan market, spurred by a rise in collateralized loan obligations and low interest rates, has swelled in recent years and now tops $1 trillion, according to the Federal Reserve. Leveraged loans often get bundled into CLOs.

That rise in popularity has drawn the attention of regulators, to the point that leveraged loans will play a key role in the Fed's annual Comprehensive Capital Analysis and Review test.

The Fed will use CCAR to pull in more data on how leveraged loans and CLOs will perform in a recession. The research is important because leveraged loans can be an early indicator of deteriorating credit quality, which in turn could hurt banks’ profitability and usher in an economic slump, industry experts said.

“This kind of lending does often involve companies with questionable credit,” said Kevin Jacques, a finance professor at Baldwin Wallace University who previously worked on risk management matters at the Office of the Comptroller of the Currency.

“We need to have a better understanding of what happens with these loans in a recession and, for instance, if rates change course and suddenly go up,” Jacques added. “That would raise the cost of borrowing and could trigger defaults.”

This year’s CCAR includes a scenario where heightened stress on highly leveraged markets causes CLOs and private equity investments to endure notably larger market value declines than last year.

Banks will also be required to look at what would happen if there is a spike in short-term interbank lending rates. The 2019 CCAR evaluated a decline in those rates.

CLOs have been on the Fed’s radar for several months.

Randy Quarles, the Fed’s vice chairman of supervision, said late in 2019 that the regulator was analyzing CLO exposure, particularly leveraged loans to companies with high debt levels. U.S. nonfinancial corporate debt reached a record high of nearly 50% of gross domestic product last year, according to the Fed.

In a recent report, the Financial Stability Board warned about the heighted risk that leverage lending poses to the international financial system.

The report stated that vulnerabilities in the leveraged credit markets had expanded since the financial crisis. The global watchdog pointed to increased debt levels, lower quality corporate debt, and increased complexity in leveraged loans and CLOs.

The FSB said big, international banks have the largest direct exposures to leveraged loans — more than other types of financial companies — and, collectively, the exposure comes with “significant cross-border dimension.”

Those findings suggest that banks are partnered in syndicated loans, which could mean that one bank’s problems could spread to others, creating systemic challenges, Jacques said.

“This is a potentially really large issue,” Jacques said. “I’m not trying to sound alarm bells. Credit conditions overall are very good still. But this is an area where it is smart to get way ahead of any problems.”

While the biggest banks have the most exposure, smaller banks are the ones reporting early struggles with leveraged loans.

Texas Capital Bancshares in Dallas, for one, said it worked to run off leveraged loans last year after enduring increased charge-offs.

The $32.5 billion-asset company aims “to minimize downside impact” and is “actively monitoring all portfolios” for any possible credit cracks, Chief Financial Officer Julie Anderson said during a recent earnings call.

Cadence Bancorp. in Houston said its credit deteriorated further in the fourth quarter — following problems in each of the two prior quarters — as the $18 billion-asset company dealt with leveraged loans. Cadence is cutting back its exposure aggressively, Chairman and CEO Paul Murphy Jr. said during Cadence’s earnings call.

“Every time we look at a credit that has higher leverage, we are scrubbing it extra hard,” Murphy said. “We're either working in a way to strengthen the structure [of loan terms] or we're asking them to refinance and find a different lender.”

Problems at smaller banks appear mostly isolated to date, but they do raise cautionary flags and support the Fed’s increased focus on leveraged lending, said Lawrence White, an economist and professor at New York University’s Stern School of Business.

“It’s much better to identify problems early and find fixes, rather than wait for things to bust and have all sorts of messes to clean up,” White said.

The other elements of the severely adverse scenario that big banks face under CCAR are relatively consistent with 2019’s parameters: 10% unemployment, plummeting home values, sinking stock prices and falling inflation. The hit to GDP is more severe.

Evercore ISI analysts Glenn Schorr and John Pancari, in a recent note to clients, described this year’s scenario as being “slightly worse” than in 2019.

“To be clear, we don’t think any of these will be devastating to capital return, just worse on relative terms to last year, so likely less excess capital and lower payouts,” the analysts said.

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Community banking Stress tests Leveraged loans CLOs