Leveraged loans are threat to economy

In classical music it was standard practice for composers to give Italian names to the different movements, or major sections, to prepare the listeners and inform the musicians about the general mood being expressed. A typical symphony, for example, might open with an energetic allegro movement, become lyrical with an adagio, and end with a rondo.

There are movements in financial markets, too, and it might be helpful to give them names. One of the first to get a name should be, without doubt, today’s higher risk lending movement and in pseudo-Italian it should be called, leveraggio, in honor of its usual financial instrument, the leveraged loan.

Leveraged loans got their name originally as the bank loans used to finance leveraged buyouts. Whatever the merits of leveraged buyouts might be, their risk was contained to a few players — the bank, the company’s owners, and anyone extending credit to the business.

Today’s leveraged loans are not tied at all to corporate buyouts, leveraged or not. Instead they are made to a business with a sub-prime credit rating — usually due to already existing loans outstanding. The businesses pay a higher interest rate, of course, and the banks package up these loans and sell them to investment banks, hedge funds, and pension funds.

In terms of risk to our economy, volume counts. A few leveraged loans here and there might be unwise but they would not represent a threat to the U.S. or global economy.

What started as a type of occasional, “faith-based” loan, made on the basis of a belief in the management of the borrowing company and its business plan, has become a market movement that now totals $1.7 trillion.

If you are thinking that sounds a lot like sub-prime mortgages before that market collapsed and dragged us into a recession, you are in good company. Banking regulators at the Office of the Controller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve have become increasingly alarmed at the growth of leveraged loans.

One of the problems that leveraged loans bring with them is a significant deterioration in underwriting standards. This, too, was a characteristic of the sub-prime mortgage market, as demonstrated in the “low-doc” and “no-doc” loans made despite poor quality or non-existent documentation regarding the borrower’s income, debts, and credit worthiness.

There is no hard, statistical evidence but it seems that one successful “wildcat” operation within a bank often tends to tempt or encourage others, and the result will be slippage in bank-wide lending standards and a deterioration of management control.

What little we know about the organizational dynamics of this process comes from revelations turned up during a disaster relief effort of one sort or another after a bank collapses. There might be multiple causes, but the apparent linkage between lowered credit standards and things like “disaster” and “collapse” should be enough to make us think beyond the bottom line about how a bank’s profits are being earned.

Profit is driving the leveraged loan market. Because of the additional credit risk, these loans are made at higher rates than ordinary commercial loans. Leveraged loans also offer opportunities for growth, which is important in a world of impatient investors. Because of our painfully slow economic recovery and low interest rate monetary policy there have been few opportunities for growth in standard commercial loans.

Lastly, leveraged loans offer the opportunity to maximize fee income and, perhaps, minimize risk because the loans are packaged up and sold to investors. The precise extent of liability and risk that the originating bank retains after the sale is still not absolutely clear, and its fate remains in the hands of lawyers, courts, and regulators. Some risk still exists though. It is not zero.

In addition to the originating bank’s risk there is a systemic risk, which is probably more important. If the $1.7 trillion leveraged loan market were to collapse of its own weight, for example, it could trigger a liquidity crisis in our financial markets.

The leveraged loan market resembles a perfect reenactment of the mortgage loan market bubble that popped the economy into a deep recession. There is one difference, though. This time the regulators are not asleep.

The regulators are doing a good job by issuing warnings about the leveraged loan market. Multiple warnings from different regulatory authorities, though, reflect an unfortunate characteristic of our current financial system: lots of regulators, piles of regulations, and no clear, single point of responsibility, authority, and action. No single entity is responsible and in charge. Despite the warnings, then, the leveraged loan situation is a script for a rerun of Wall Street’s 2008-09 implosion, with a musical score marked, “leveraggio.” It’s not a happy tune

James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.