U.S. Guidance Could Deter Levered Loans

Final U.S. leveraged lending market guidance, expected in early 2013, will alter bank risk management’s blueprint for the first time in a dozen years, just as this funding stages a comeback from a financial crisis slide, sister service Thomson Reuters Loan Pricing Corp. reported. Aspects of the proposed interagency guidance, like other regulatory overhauls being considered including revising the 35-year-old U.S. bankruptcy code, could drive out willing lenders and drive up borrowing costs, loan industry advocates and tax attorneys said.

As outlined by the Federal Reserve, FDIC and the OCC, the guidance could meaningfully increase loans on banks’ books classified as “leveraged” or “criticized” for repayment risk. Banks would need to beef up reserves to buffer potential losses for the larger pool of loans considered as leveraged, tying up funds that could be otherwise used for lending.

The agencies in a joint statement last March, noting the importance of leveraged finance for the economy, said banks play an integral role in making credit available and syndicating that credit to investors. Their push for tighter safety standards follows “tremendous growth in the volume of leveraged credit leading up to the crisis and in the participation of non-regulated investors.”

The financial crisis dragged outstanding institutional loans as measured by the S&P/LSTA Leveraged Loan Index under $500 billion in 2011 from about $600 billion in 2008, but volume has since rebounded to about $550 billion. The upturn comes as “prudent underwriting practices have deteriorated” and debt agreements often provide relatively limited lender protection, the federal agencies said. To tackle this, their guidance addresses risk and pipeline management as well as underwriting and valuation standards.

Expanding the definition of leveraged finance is a facet of the guidance that LSTA worries will deter lenders. Including “fallen angels”—loans to companies that start out as investment-grade but sink to junk—and loans to financial vehicles such as collateralized loan obligations because they engage in leveraged finance, could vastly increase banks’ leveraged loan portfolios, the industry group said.

In an August comment letter to the agencies, LSTA and the American Bankers Association countered that leveraged loans should refer only to those deemed leveraged when originated. “We’re very concerned with fallen angels and other loans that weren’t leveraged when they were created, as it is very difficult to predict when these loans would trigger the leveraged loan definition,” LSTA general counsel Elliot Ganz said.

Corporate fraud and other unanticipated events push some companies into this category. Requiring banks to categorize these loans as leveraged would mean artificially beefing up reserves, reducing funds available for “actual” leveraged lending, Ganz said. Proposed guidance applies to loans arranged and held by banks, and refers to banks’ “fiduciary responsibility” in underwriting and distributing loans. LSTA argues this responsibility exists neither as a matter of law or market practice, and could expose banks to significant liability.

Lenders need to do their own due diligence, said Ganz. “To say that the underwriter has that duty would impose a standard of liability that would make it very difficult for them to do business and have huge implications. They’re not getting paid to provide insurance, which is essentially what a fiduciary standard means.”

A top risk is that banks may take excessive risks to improve profitability, OCC contends. Examiners found 38 percent of banks loosening standards on highly leveraged lending, according to OCC’s 2012 Survey of Credit Underwriting Practices.

Some of the most damaging guidance could be amended, loan industry experts said. “They’re trying to thread the needle and take a middle road,” Barbara Goodstein, a partner in the Chicago law firm Mayer Brown, said of the agencies. “They’re really not looking to put a full stop on this market, but they don’t feel like they had enough traction from what they did in 2001.”

Rigid 1989 guidance repelled lenders concerned about boosting required regulatory capital for leveraged transactions, and was replaced with “softer” guidance in 2001, she said. The market has since evolved, layering in “aggressive structures” such as covenant-lite provisions and PIK toggles that warrant heightened scrutiny, she added.

“What’s at stake probably for the industry is whether the feds are going to have the same problem on their hands as in 1989,” said Goodstein. “Is it going to wind up—and this is something that is definitely of concern to the feds—pushing the banking industry so hard in creating so many compliance issues that some of the banks start to withdraw from leveraged lending?”

Borrowers could also cancel deals to avert regulatory criticism and higher costs, or seek financing from unregulated lenders, industry experts said.

“If you make leveraged loans less available, or more expensive, companies that can’t obtain credit in any other way will not be able to obtain credit,” LSTA’s Ganz said. “Therefore, companies that are job creators will have a harder time doing business.”

Lynn Adler is a reporter for for Thomson Reuters LPC.