Over the past few years, the press, regulators and market alarmists have identified leveraged loans as a post-crisis target for overwrought scrutiny. Most notably, federal bank regulators in 2013 issued guidance telling banks to improve risk management and underwriting for leveraged loans, and have pressured institutions to moderate the issuance of leveraged loans. Just in November, the agencies' "Shared National Credit" review reiterated their concerns about leveraged loans.
But the negative attention overlooks the critical source of financing leveraged loans provide for many American companies, thereby serving as a key building block for the U.S. economy. Were leveraged loans materially reduced through onerous regulations, it would hurt the job-creating companies that rely on them.
Recipients of these loans are businesses we all know and likely use every day: companies like Delta, Wendy's, Hilton Hotels, 24 Hour Fitness and more. Currently, these loans provide over $1.2 trillion in financing to American companies that might not otherwise have access to the debt markets. These companies then use the funding to expand, grow, take on additional projects or weather tough times.
For example, Ford Motor Co. raised $18 billion in leveraged loan commitments in late 2006 to finance a complete overhaul of its lagging business. The financing not only helped reposition Ford to be the most competitive of the "Big Three" automakers, but it also provided a liquidity cushion during the 2007-9 recession that helped Ford, unlike its peers, stay out of bankruptcy.
In the press, at least, borrowers of leveraged loans are often stigmatized as having collapsing capital structures and high levels of stress. This is simply not the case. In fact, as early as 1987, University of Florida professor Christopher James reported in the Journal of Financial Economics that when public companies announced a new bank loan, their stock price actually jumped in reaction to the news. In other words, the market views raising new bank debt financing as a positive development, not a negative one.
This finding was reinforced by subsequent studies. According to separate studies James conducted with Peggy Wier, in 1990, and Charles Hadlock, in 2002, bank lending helps ensure that firms are properly valued, increasing the likelihood of a successful IPO or positive stock price responses in the future.
Additionally, research by Harvard professor Michael Jensen argues that when a company takes on debt, even high levels of debt, this pushes it to remain on track and in some cases perform better. This is likely due to the fact that high levels of debt create incentives for managers and owners to maintain high performance levels in order to make timely loan payments or risk losing their firms.
Many also fail to see the unique advantages leveraged lending provides to borrowers. In a study that I conducted in 2012 along with Greg Nini and Amir Sufi, we found that leveraged loans uniquely position banks to monitor borrower performance. If performance declines or shows signs of a future default, lenders can step in to monitor the borrower even more closely, tightening or loosening loan terms as warranted and counseling the borrower on how to improve performance.
This important disciplining mechanism that can propel corporate borrowers to thrive in the future is unique to bank lending. If regulators limit this market, firms seeking financing could be forced to rely on riskier sources of liquidity that fail to provide similar safety measures and monitoring that accompany leveraged loans.
No one argues with the necessity for regulators to examine our financial institutions and make changes that will allow markets to function more effectively. We should, however, object to instances where excessive regulation and misguided scrutiny can result in unintended negative consequences. Leveraged loans are not exposing the capital markets to unnecessary risk and provide unique benefits to borrowers and lenders alike. They are crucial to American businesses that provide needed products and services to our country.
David C. Smith is the director of the McIntire Center for Financial Innovation and the Virginia Bankers Association Professor of Commerce at the University of Virginia.
Corrected January 26, 2016 at 3:57PM: A longer version of this post is expected to be published as a white paper later this year.