Since 2013, the federal regulatory agencies have been warning banks and investors about the potential risks in leveraged lending. These warnings have been both timely and prescient, particularly in view of the ongoing credit debacle in the energy sector. In addition to the well-documented credit risk posed by leverage loans, we believe that the widespread practice of selling participations in leveraged loans represents a significant additional risk to financial institutions and other investors from this asset class.

While regulators have appropriately focused on the credit risk component of leveraged loans held by banks and nonbanks alike, the use of participations to distribute risk exposures to other banks and nonbank investors also raises significant prudential and systemic risk concerns. The weakness in oil prices, for example, has caused investors to cut exposure to companies in the energy sector. This shift in asset allocations caused by the decline in oil prices has negatively impacted prices for leveraged loans and high yield bonds. In some cases, holders of these securities are attempting to exit these exposures by securitizing the participations.

The investor exodus away from leveraged loans with exposure to the petroleum sector brings back memories of the 1970s oil bust, an economic shock that led to the failure of Penn Square Bank in 1982, the subsequent failure of Seafirst Bank later in that year, followed by Continental Illinois Bank in 1984. Before its failure, Penn Square technically continued to "own" — and service — loan interests held by other banks with participations. As receiver for the failed bank, the Federal Deposit Insurance Corp. deemed those investors to be nothing more than general creditors of the failed bank's estate. Those participating banks lost their entire investment.

As in the 1970s, today a substantial portion of the leveraged loan market has been "participated" to other banks and nonbank investors. A loan participation is an intangible asset that in theory evidences a purchaser's right to future payments from a loan or lease. Many banks and other market participants believe that the purchase of a loan participation is necessarily a "payment intangible" and therefore classified as a secured interest under Article 9 of the Uniform Commercial Code, but this is not always the case.

In fact, the FDIC will, on receivership of a failed bank, assert that with respect to participations on loans held in the bank's portfolio there was never a transfer of any "asset" away from the originating bank. In other words, the participation is not viewed as a true "sale." When a bank fails, the FDIC quite regularly offers "participants" a choice of being treated, in effect, as a subordinate creditor of the lead bank's receiver unless the participant purchases (at par, regardless of actual value) the entire asset. The repudiation of loan participations by the FDIC was upheld by every court that reviewed FDIC's actions as receiver for the failed Penn Square Bank.

In the years since the Penn Square failure, when the Financial Accounting Standards Board considered the treatment of loan participations, the FDIC specifically advised the FASB of this treatment for participations in the event of a bank failure. When the FASB asked whether the FDIC was willing to revise that position for future receivership actions, the FDIC confirmed that it would certainly assert the same position in any future situation similar to Penn Square. The basis of the FDIC's position is that there was never a "transfer" of the underlying asset.

As already noted, the actions by the FDIC in the Penn Square receivership led to the failures of Seafirst and Continental Illinois in the early 1980s. Three other banks — Michigan National Bank, Northern Trust and Chase Manhattan — were badly hurt by losses tied to loan participations from Penn Square. Eventually, Michigan National Bank became part of Bank One, which along with Chase Manhattan was folded into JPMorgan Chase. The assets of Seafirst and Continental Illinois were eventually sold to Bank of America.

The Penn Square cases make it clear that the FDIC has an absolute right to re-characterize a participation as the incurrence of, at best, a secured liability by the lead bank. In the case of nonbank sponsors of participated loans, bankruptcy trustees have similar rights. The inherent ambiguity of a "participation," which can be characterized either as an incomplete "sale" of an asset or as a "liability" of the lead bank, should be an obvious concern to investors.

After the 1989 Financial Institutions Reform, Recovery, and Enforcement Act and subsequent legislation, questions about the claims of participation holders in a failed-bank receivership are now compounded by the order of priority for other types of claimants. Unsecured claims against insolvent banks are subordinate to all deposit claims, whether deposits are insured or not. Thus, any future decision upholding, for example, the Penn Square precedent might result in subordination of participant rights not only to the FDIC but to claims of uninsured depositors — a result that would likely leave participants with valueless claims.

In addition, the subsequent secondary market sale of a participation may further erode the priority of the participant investor. Even in the case where a participant asserts "perfected" rights to underlying collateral, such participants could still fall to a low place in the priority chain.

The FDIC's repudiation of contractual loan participation agreements in its role as receiver may seem counterintuitive and even bizarre. In fact, however, the FDIC arguably is obligated to do this. The impact of encouraging participations that can be subordinated in receivership generates a very large benefit for the FDIC in its role as the deposit insurer, protector of the Deposit Insurance Fund and, ultimately, the U.S. taxpayer.

The bottom line for investors is that buying a loan participation is a very risky business. Regardless of the representations made at the time of the participation transaction, many loan participations do not meet the requisite tests for true sale as defined by the FDIC and the courts. Accordingly, banks and nonbanks alike need to be mindful not only of the credit risk associated with leveraged loans, but also of the structural issues that these transactions may raise if the exposure comes via a loan participation that does not meet the requirements of a true sale.

Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency.