When an expert in financial risk at one of the world’s most powerful private equity outfits tells investors to scale down their exposure to a specific corner of the debt market, it is worth taking notice.
Henry McVey, who sits on the risk committee at KKR, said last week that the leveraged loan market – a $1.3tn (£1tn) pile of risky corporate loans – had been on a “great run in recent years” but the firm was now cutting its exposure to the asset class to zero.
McVey is not alone in his caution. A growing chorus of global leaders spent 2018 warning that the leveraged loan mountain was getting dangerously large and inviting comparisons with the financial crisis a decade ago.
The Bank of England, Australia’s central bank, the International Monetary Fund and members of the US Federal Reserve have raised red flags over so-called leveraged loans, which are offered to companies already in debt but often come with few strings attached.
In October last year the Bank’s financial policy committee, which monitors the health of the financial system, pointedly raised the spectre of the 2007-08 credit crunch. It said the “global leveraged loan market was larger than – and was growing as quickly as – the US sub-prime mortgage market had been in 2006”.
As with the sub-prime crisis, the bank added, underwriting standards had slipped – in other words, risky corporate debt was too easy to get right now. “Given the decline in underwriting standards, investors in leveraged loans are at increasing risk of loss,” said the Bank.
The key question now is whether a bubble in a different corner of the debt market could trigger a market panic. “A quote wrongly attributed to Mark Twain fits here: history rarely repeats, but it does rhyme,” said Rasheed Saleuddin, a research associate at the University of Cambridge’s Judge Business School.
While he said it was hard to see the next financial crash coming directly from a failure in the leveraged loan market, Saleuddin added that there was a chance that “small changes in default rates in the loans or even in expectations of same could cause a meltdown”.
In the lead-up to the 2008 financial crisis, banks were so keen to lend that they liberally handed out mortgages to customers with weak or no credit histories who ended up defaulting when times got tough. Those mortgages had been bundled together and turned into investable products, causing a chain reaction of losses that spread like wildfire throughout the financial system and caused a global downturn.
A decade later, rather than doling out risky loans to homeowners, banks are handing out leveraged loans to indebted companies. Many are also “covenant-lite”, meaning they come with fewer strings attached for borrowers, and as a result, present greater risk for lenders.
Small changes in default rates in the loans or even in expectations of same could cause a meltdown
But since most loans are sold on and packaged as collateralised loan obligations, or CLOs, there are fewer incentives to impose strict terms. Leveraged loans also come with floating rates, making them more attractive for investors, who receive higher interest payments when rates rise.
Amir Amel-Zadeh, an associate professor at the University of Oxford’s Saïd Business School, explained that investors in leveraged loans, loan mutual funds and CLOs could face higher losses than investors in the same products during the 2008 crisis due to lower lending standards, an increase in covenant-lite loans and higher levels of corporate indebtedness than 10 years ago.
But while the trends in the CLO market were similar, he said the scale was nowhere near the mortgage securitisation market in 2008 – at about a tenth of the size. “So at first sight it is not as worrying from a systemic risk point of view. However, if economic conditions worsen, it can lead to losses for many investors and lead to a similar dry-up in liquidity in these instruments as we have witnessed with sub-prime mortgage securitisations during the 2008 crisis.”
Reports have already emerged that the market for CLOs may be cooling, as uncertainty grips financial markets. With fewer investors lining up to take a slice of the leveraged loan market, prices have dropped, and banks have been postponing sales of leveraged loans to investors as a result. “If banks have to keep the loans on their books they will be exposed to the price risk,” Amel-Zadeh said.
Without a hungry market to sell leveraged loans to, banks may be less willing to lend so liberally to indebted companies. And without further loans to feed their debt habits, companies could be at risk of default. This particular debt market will be one to watch in 2019.
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