Powell Says Leveraged Lending Isn't Posing a Crash Threat

(Bloomberg) -- Federal Reserve Chairman Jerome Powell agrees that the torrid market in high-risk corporate loans looks a lot like the mortgage industry in the run-up to the subprime crisis, but he says U.S. regulators are watching closely this time around and the financial system is better shielded.

In a sweeping analysis of leveraged lending Powell delivered a response to critics who argue that the Fed is asleep at the switch as another catastrophe looms. Despite obvious warning signs in these risky business loans, the central bank chairman said, the $1.2 trillion market doesn’t represent a current threat to the financial system.

“We take the risks from business debt seriously but think that the financial system appears strong enough to handle potential losses,” Powell said Monday in remarks prepared for a Fed conference in Florida. At the same time, he said, uneasiness over parallels to the 2008 crisis are understandable.

“The acronyms have changed a bit -- “CLOs” (collateralized loan obligations) instead of “CDOs” (collateralized debt obligations), for example -- but once again, we see a category of debt that is growing faster than the income of the borrowers even as lenders loosen underwriting standards,” Powell said. “Not only is the volume of debt high, but recent growth has also been concentrated in the riskier forms of debt."

He pointed to mutual funds as potentially troubling participants in today’s leveraged loan market, where investors have been whipped into a frenzy over eagerness for yield. A downturn might encourage investors to redeem shares much faster than the funds can sell off the loans, he said.

“Widespread redemptions by investors, in turn, could lead to widespread price pressures, which could affect all holders of loans, including CLOs and those that hold CLOs,” he said of the securities that hold the bulk of leveraged loans -- $709 billion at the moment. The next biggest chunk -- $224 billion -- is in mutual funds.

Democratic senators -- including 2020 presidential contender Elizabeth Warren and Sherrod Brown, the party’s ranking member on the Banking Committee -- have demanded that federal agencies get a better handle on the market. Brown last month accused Treasury Secretary Steven Mnuchin and the regulators of having “failed to take any decisive action.”

Powell on Monday argued that CLOs have more stable structures than the infamous securities of the last crisis, with regulators keeping closer watch, banks in much better shape and the financial system carrying less debt than in 2008. He said the Financial Stability Oversight Council has been having deep discussions about leveraged lending, adding that the Securities and Exchange Commission is looking for liquidity trouble at mutual funds and the Commodity Futures Trading Commission is assessing the use of derivatives to hedge risk.

The Fed chairman echoed a view expressed recently by Randal Quarles, the central bank’s vice chairman for supervision. Both say regulators need to find out who in the world is investing in the lion’s share of CLOs, both arguing that it’s not U.S. banks. Global regulators have begun searching out that answer, they said.

“We cannot be satisfied with our current level of knowledge about these markets,” Powell said.

To contact the reporter on this story: Jesse Hamilton in Washington at jhamilton33@bloomberg.net

To contact the editors responsible for this story: Jesse Westbrook at jwestbrook1@bloomberg.net, Gregory Mott

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