System can withstand threat posed by leveraged lending: Powell

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WASHINGTON—Federal Reserve Chair Jerome Powell highlighted historic leveraged lending and corporate debt as threats to the financial system in a speech Monday, warning that borrowers could face stress if the economy were to weaken.

Following the Fed’s Financial Stability Report, which was released May 6, that found the least creditworthy borrowers account for a significant proportion of the sharp growth of business debt, Powell offered more information on the leveraged loans that the regulator is closely watching.

“In public discussion of this issue, views seem to range from ‘This is a rerun of the subprime mortgage crisis’ to ‘Nothing to worry about here,’” Powell said at a Federal Reserve Bank of Atlanta Conference in Florida. “At the moment, the truth is likely somewhere in the middle.”

Although the Fed is taking the risks that corporate debt poses seriously, Powell said he ultimately believes that the financial system is healthy enough to handle potential losses.

“Together with our domestic and international counterparts, we are monitoring developments in business debt markets, working to develop and share data on how these markets operate, studying ways to further strengthen the system, and working to ensure that banks are properly managing the business debt risks they have taken on,” he said.

Still, he said regulators are keeping a close watch on the situation. The increase in leveraged lending is concentrated in riskier forms of debt, presenting one concern for the Fed.

The rise in riskier business borrowing can mostly be attributed to nonbank lenders, Powell said, with collateralized loan obligations making up about 62% of outstanding leveraged loans. Mutual funds account for about 20% of the leveraged loan market, and could be a pressure point in the event of an economic downturn, he said.

“Investors may react to financial stress by trying to redeem their shares before the funds have sold their most liquid assets,” said Powell. “Widespread redemptions by investors, in turn, could lead to widespread price pressures, which could affect all holders of loans, including CLOs and those that hold CLOs.”

Underwriting standards have also weakened, he said, echoing the agency’s Financial Stability Report, which found that underwriting standards have subsided even since the Fed’s last report in November.

“With leveraged loans, covenants intended to protect lenders may be an endangered species; more loans now feature high debt-to-earnings ratios; and the use of optimistic projections including ‘earnings add-backs’ is becoming more common,” said Powell.

Although economic conditions remain strong, businesses would face challenges during periods of financial instability, Powell said. However, the current state of business debt doesn’t pose a heightened risk to the financial system that would “lead to broad harm to households and businesses should conditions deteriorate.”

While the situation may appear similar to the subprime mortgage crisis, Powell emphasized that there are key differences, including frequent Federal Reserve Board meetings in place now to assess threats to the financial system and the use of a checklist of potential financial vulnerabilities.

Powell also outlined a number of supervisory efforts the agency is conducting, including “qualitatively assessing how well banks are managing the risks associated with leveraged lending.”

Fed supervisors are also working with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation through the Shared National Credit Program to confirm that banks are managing the risk of losses they could face by holding leveraged loans.

Leveraged lending has also been a topic of discussion at meetings of the Financial Stability Oversight Council, said Powell.

“We recognize that each regulator directly sees only a part of the larger picture, and we are working to stitch these parts together so we can collectively see that larger picture and the risks it holds,” he said.

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