THE SURPRISING LOSERS IF U.S. LEVERAGED LOAN BOOM FIZZLES THE WALL STREET JOURNAL

The Surprising Losers if U.S. Leveraged Loan Boom Fizzles

U.S. regulators and others are casting a closer eye over aggressive loans for private-equity deals

By Paul J. Davies

The $1.3 trillion market for risky loans used in private-equity deals has regulators worried.

Activity in the U.S. market has boomed and it is U.S. officials leading the warning calls. But, while U.S. investment banks lead many businesses, it is the big Europeans that punch above their weight in U.S. loans and that face the bigger risks. For Credit Suisse , Barclaysand Deutsche Bank ,leveraged loans bring in a bigger share of investment bank revenue than they do for JP Morgan ,Bank of America Merrill Lynch and Goldman Sachs .

Standards in the leveraged loan market have been slipping as more aggressive private-equity deals have pushed debt multiples higher and eviscerated the traditional protections, known as covenants, that allow lenders to intervene if borrowers start to struggle.

The latest warning on leveraged loans came from Federal Reserve banking regulator Todd Vermilyea last Wednesday. He highlighted many of the aggressive practices that have been regularly covered in this column and told an industry conference that the Fed was taking a closer look at banks’ risk management. Janet Yellen, former Fed chair, also raised concerns about the market last week in a newspaper interview, while Fed officials at their latest monetary policy meeting discussed the growth of loans, loosening of standards and role of non-banks in the market, according to minutes released this month.

Federal Reserve banking regulator Todd Vermilyea said the Fed was taking a closer look at banks’ risk management. Photo: chris wattie/Reuters 


Meanwhile, the Bank of England’s financial stability committee said it would assess the risks posed to banks by this market in this year’s stress test after it noted that global leveraged loans were larger than U.S. subprime mortgages in 2006 and growing as quickly.

European banks and some U.S. brokers like Jefferies Financial Grouphave been competing harder in leveraged loans in part because they don’t do so well against top U.S. banks in winning mandates to advise on mergers and acquisitions, according to an industry report from Morgan Stanleyand Oliver Wyman earlier this year.

Last week, Deutsche Bank was quizzed on its third-quarter results call by analysts about whether it was the right time to be increasing its market share in leveraged loans. Christian Sewing, the chief executive, said he was absolutely confident Deutsche wasn’t taking undue risks.

JP Morgan has the most revenue from U.S. leveraged loan deals this year so far—a spot occupied by Credit Suisse for each of the past five years, according to Dealogic—although this revenue is still less important to JPMorgan than it is to Credit Suisse.

Banks tend not to hold these loans. Instead, they sell them to other investors, especially mutual funds and collateralized loan obligations. However, if the market freezes, banks can get stuck with this debt, as many discovered to their dismay in 2007.

Any effort by regulators to cool the market, or any market problem that stops banks from selling the loans, would have a cost for all those involved: For the Europeans, though, the proportion of revenue and capital affected would be greater. Leveraged finance revenue is worth about 12% of advisory and capital raising revenue on average for the three Europeans, according to UBS ,while it is worth just 7% for the five largest U.S. banks.

These banks might ultimately thank the Fed, or another regulator, that acted to cool the market. Foregone revenue notwithstanding, it could save them from a bigger accident to come.