November 15, 2018

Warren Presses Regulators on Risks in Leveraged Lending Market

Warren raises concerns that poor underwriting and minimal protections in leveraged corporate lending could pose serious risks to financial system and economy

Washington, D.C. - United States Senator Elizabeth Warren (D-Mass) today sent a letter to Treasury Secretary Steven Mnuchin, Federal Reserve Chairman Jerome Powell, Comptroller of the Currency Joseph Otting, Federal Deposit Insurance Corporation Chairman Jelena McWilliams, and Securities and Exchange Commission Chairman Jay Clayton, expressing concern about the rapid growth of leveraged corporate lending and the inadequate response from the Financial Stability Oversight Council and federal regulators. 
Leveraged lending – lending to companies that are already highly indebted – is at record levels. During the first nine months of this year, financial institutions issued $1.1 trillion in leveraged loans in the U.S – about 25 percent of all business loans in America. Loan underwriting is also weakening as lenders are including fewer terms to protect themselves in case of losses. Many of the loans are securitized and sold to institutional and retail investors as part of collateralized loan obligations (CLOs).
Senator Warren wrote, “I am concerned that the large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market. These loans are generally poorly underwritten and include few protections for lenders and investors. Many of the loans are securitized and sold to investors, spreading the risk of default throughout the system and allowing the loan originators to pass the risk of poor underwriting on to investors. And the loans include adjustable interest rates – which means that if the Federal Reserve continues to raise interest rates in the upcoming years, companies will face rising interest costs just as the economy starts to slow down.” 
She added, “I fear that continued growth in leveraged lending – along with the steady degradation in loan terms – creates significant risk to the financial system and the American economy.”
In sending this letter, Senator Warren joins the growing chorus of experts ringing alarm bells about the leveraged loan market.
Former Federal Reserve Chair Janet Yellen said in October that she is “worried about the systemic risks associated with these loans,” in part because “[t]here has been a huge deterioration in standards” and “covenants have been loosened.” Former Federal Reserve Governor Daniel Tarullo recently said the leveraged lending market “is an originate-to-distribute model again,” and “[t]here is nobody charged with looking at whether it is creating a risk of cascading consequences.” And the Bank of England noted in October that global leveraged loan market is bigger than the U.S. subprime mortgage market in 2006, and that like the American subprime market in the pre-crisis period, “underwriting standards [have] weakened.”
Senator Warren also noted that regulators in the Obama Administration had issued joint guidance in 2013 to address potential risks in the leveraged lending market, but that regulators in Trump Administration had backed off of the guidance.
To gather more information about regulatory actions being taken to mitigate the risk posed by highly leveraged corporate loans, Senator Warren requested answers to the following questions by December 11, 2018: 
To Secretary Mnuchin:
1. The leveraged lending market involves a number of different types of entities that are subject to oversight from a number of different federal regulators. Congress created FSOC to ensure adequate oversight of such cross-cutting markets. In your capacity as the head of FSOC, what is FSOC doing to monitor the growing leveraged lending market and to coordinate responses across the different agencies with relevant jurisdiction? Is the Office of Financial Research looking into the growing risks in this market?
To Chairman Powell, Comptroller Otting, Chairman McWilliams, and Chairman Clayton:
2. The Volcker Rule is intended to restrict bank involvement with external funds, including securitizations. Securitizations like CLOs are central to the leveraged lending market. Trade associations have asked you to significantly loosen Volcker Rule controls on bank involvement with CLOs, and questions in your latest Volcker Rule proposal suggest you are considering greatly broadening permissible external funds activities by banks. Expanding securitization exemptions as requested by industry trade groups could significantly increase such holdings and produce bank involvement in more complex CLO re-securitizations and synthetic securitizations. Have you investigated how such liberalization in Volcker Rule standards could affect underwriting in the leveraged lending market, and whether it could lead to a proliferation of complex leveraged lending securitizations that would be more difficult for ratings agencies and investors to assess?
To Chairman Powell, Comptroller Otting, and Chairman McWilliams:
3. Do you share the concerns of former Federal Reserve Chair Yellen, former Federal Reserve Governor Tarullo, and the Bank of England, among others, about the leveraged loan market?
4. How does your agency currently view the 2013 leveraged lending guidance? Is the guidance still in effect? Do your agencies monitor compliance with the guidance? If institutions under your supervision violate the guidance, will you issue supervisory findings or otherwise direct the institutions to come into compliance with the guidance?
5. What plans, if any, does your agency have to address growing risks in the leveraged lending market?
To Chairman Clayton:
1. Do you have concerns about CLO market for leveraged loans?
2. As you know, the Dodd-Frank Act established an Office of Credit Ratings within the SEC that is responsible for promoting the accuracy of credit ratings issued by Nationally Recognized Statistical Ratings Organizations (NRSROs) and ensuring that such ratings are not unduly influenced by conflicts of interest or sales considerations.
a. In your supervision of NRSROs, do you find any evidence that ratings of leveraged loans and CLOs are lacking in accuracy or are unduly influenced by conflicts of interest or sales considerations?
b. How is the increasing prevalence of “covenant-light” loans incorporated into the formal NRSRO ratings of such loans? For example, are the “covenant score” metrics generated by certain NRSROs incorporated or taken into account in their methodologies for     producing rating