Garnet Capital Advisors Blog

Excerpt: There is great concern over the prevalence of leveraged loans and the potentially negative effect they may have on the banking industry if a blow-up occurs.

Are leveraged loans a systemic problem in the banking industry?

Is the banking industry treading in rough waters as leveraged loans evidence signs of stress?

Leveraged loans are those that are given to companies that already heavily in debt. As such, they typically carry more risk for lenders. Corporate borrowers who take out leveraged loans also pay more interest as the Federal Reserve hikes rates and secures the loans with underlying collateral.

Leveraged loans typically get priority over high-yield credit, which means lenders of leveraged loans get paid first, giving them a bit of protection if the borrower goes under. In fact, 2018 was a pretty good year for leveraged loans as compared to most other assets.

While an increasing amount of leveraged lending is being underwritten by non-banking institutions like private equity and securities firms that fall outside the boundaries of regulation, U.S. banks are still currently the largest leveraged loan underwriters.

Thanks to the leveraged loan market, many companies have been able to snag cheap financing over the recent past. With credit requirements being laxer, more highly-indebted entities have been able to get their hands on the financing needed.

But at what cost to the economy?

These days, the leveraged loan market is massive, doubling to approximately $1.2 trillion over the past decade. It's certainly a crowded market, with leveraged loan deals comprising about half of new corporate debt in the U.S.

A large proportion of leveraged loans on loan portfolios could place lenders in a precarious position.

With an increase in demand for loans among borrowers has come an increase in borrower power, leading to a diluting of covenants in loan agreements that have conventionally been included to protect investors.

Today, about 80 percent of leveraged loans are "covenant-lite," which means they come with fewer restrictions on the borrower and weaker protections for the lender. They're less stringent when it comes to collateral, revenue, and the loan payment terms.

Before the financial crisis, covenant-lite loans were at a mere 25 percent.

Should an economic downturn occur, the repercussions could be major.  

Loans with stronger covenants protect both lenders and investors as they come with a higher level of transparency that helps any underlying issues be identified. But with such weak covenants and a huge proportion of loans in the market being leveraged loans, the banking industry could be seriously impacted.

And with the current cry over leveraged loans and the potential negative effect that they may have comes the need for banks to adjust their leveraged loan portfolios.

The banking sector is already taking steps to adequately address this issue by:

• Limiting their leveraged loan assets on the books to 8 percent;
• Not renewing weaker credits, but rather letting them refinance elsewhere;
• Selling weaker, lower-rated loans well before the end of their term.

As a seasoned loan sale advisor that has helped countless lenders and financial institutions strengthen their loan portfolios, Garnet Capital is a pillar in the realm of loan portfolios.

And in this heavily-leveraged loan environment, all banks and financial institutions are encouraged to take steps to limit their risky leveraged loan assets and fill their portfolios with more durable, well-performing ones.

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