Christopher Whalen's recent op-ed, "A Cautionary Tale From the '80s for Today's Loan Participations," was overall misleading in its warnings about the current market for leveraged loans and loan participations, and demonstrates a misunderstanding about how the loan market works. In assessing the risk of participations exposed to the energy market or other sectors, one must consider the following important facts.
First of all, Whalen's concerns about leveraged loans to the oil and gas industry overlook the limited exposure of the leveraged market to the energy sector. The exposure of the broadly syndicated loan market to oil and gas comprise slightly more than 4% of outstanding leveraged loans, according to Thomson Reuters LPC. Although that industry is clearly going through tough times, given that it represents such a small percentage of outstanding loan issuance in the leveraged loan market, its overall impact on the loan market is entirely manageable.
Secondly, Whalen's characterization of the practice of selling participation in leveraged loans as "widespread" was also misleading. That is because no widespread practice of selling participations exists in the leveraged loan market. Indeed, market participants generally estimate that considerably less than 5% of all leveraged loan trades settle as participations.
In fact, nearly all loan trades in the leveraged loan market do not even settle as participations. They settle as "assignments," where the existing lender assigns its rights and obligations to the buyer, who then stands in for — and has no further exposure to — the old lender. Moreover, in the rare instances when a loan trade is settled as a participation, a model form of participation agreement developed by the Loan Syndications and Trading Association seeks to preclude further risk. Under the LSTA's framework, which is universally used in the U.S. loan market, the buyer acquires 100% participation interest in the loan, and the seller retains only the loan's bare legal title.
Under this structure, the buyer assumes only the credit risk of the borrower of the underlying loan, as it would with a loan assignment, not the credit risk of the seller.
Whalen's claims of inherent ambiguity in whether a loan participation that can be characterized either as an incomplete "sale" of an asset or as a liability of the lead bank are also misleading. While the Penn Square failure did prompt questions over the Federal Deposit Insurance Corp.'s treatment of such participations in a failure — and indeed some participants experienced haircuts in their receivership claims — Whalen fails to convey how today's U.S. loan market typically recognizes loan participation sales as true sales, which affords them sale accounting treatment.
This tends to be the reality in the bankruptcy environment. If the seller of the participation becomes bankrupt, the participation is not part of the bankrupt seller's estate, and, consequently, that estate will have no claim to the underlying loan or the related interest and principal payments. Indeed, when Lehman Brothers filed for bankruptcy in 2008, both Lehman and the Creditors Committee agreed with the characterization of Lehman's transfer of loan participations as true sales, and each of those participations (which had been sold by Lehman and documented on the LSTA's standard form) were afforded sale treatment. Those participations were not regarded as unsecured financings or liabilities of Lehman, and in no instance was the underlying loan considered to be part of the Lehman estate.
While it is true that many banks were harmed by the Penn Square fiasco, the fundamental cause was in fact sloppy (or nonexistent) underwriting by banks that blindly purchased unsound loans from Penn Square, not the nature of the participations.
In truth, buying a loan participation is a rare occurrence indeed in the U.S. loan market, and it is by no means risky business.
Elliot Ganz is executive vice president and general counsel, and Bridget Marsh is executive vice president and deputy general counsel, of the Loan Syndications and Trading Association.