Loose Leveraged Lending Is Storing Up Economic Trouble, BIS Says

(Bloomberg) -- One of the world’s senior financial regulators is sounding the alarm about surging high-risk lending.

The Bank for International Settlements warned that likely distress among indebted borrowers may spread into the wider economy as central banks raise interest rates. It’s not just the total debt, but the fact that investors seem less and less concerned about protecting themselves against losses, the BIS said.

The total of leveraged loans and high-yield bonds outstanding in Europe and the U.S. has doubled to about $2.65 trillion since the financial crisis, according to the Basel, Switzerland-based BIS, known as the central bank for central banks. While high-yield bonds still account for more than half the tally, growth in lending to risky companies has outpaced sales of those securities, and leveraged loans now account for almost 45 percent of the market.

Distress among indebted borrowers “may affect not only investors holding these loans, but also the broader economy,” economist Tirupam Goel wrote in the BIS’s Quarterly Report.

Goel warned that investors may be getting complacent about falling default rates, which are likely to drop to 2 percent on a global basis by year-end, down from 2.8 percent in August, according to Moody’s Investors Service.

Still more concerning is the trend toward so-called covenant-lite lending, which has seen investors waive protections in the hunt for extra yield. In the high-yield market, one recent example is the Blackstone Group LP-led $20 billion purchase of a majority stake in Thomson Reuters Corp.’s financial terminal business. Even if the company is in default, it can pay dividends or buy back stock, via a so-called mutation to the restricted payments covenant in some of the debt backing the deal.

Almost 80 percent of newly issued loans are now covenant lite, compared with less than 25 percent in 2006 and 2007, according to Moody’s. The credit-rating company tracks covenant strength with an index where higher points indicate weaker borrower protection -- and that measure is at a record.

Loose Leveraged Lending Is Storing Up Economic Trouble, BIS Says

“When there’s tons of liquidity, lenders don’t value covenants and they’re willing to lend at very high leverage values,” said Douglas Diamond, a finance professor at the University of Chicago Booth School of Business. “If you get a negative shock after that, you’ve now got a very vulnerable sector. The crisis won’t happen tomorrow but the vulnerability is there.”

The BIS report identified other concerns, including the prospect of fire sales by loan funds if ratings downgrades push some of their investments into junk. Diamond said there’s potential for such leveraged mutual funds to cause havoc.

“The borrowing that they do is usually from a bank,” he said in an interview. “They buy a loan from a bank, they borrow money from the bank to buy the loan from the bank -- not necessarily the same bank. So the risk would ultimately get back to bank balance sheets.”

Loose Leveraged Lending Is Storing Up Economic Trouble, BIS Says

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