Risks of leveraged loans rise, regulators warn – Quartz

Businesses around the world have accumulated huge debt. One concern is that these borrowers could default on some of the $ 3 trillion in risky loans, triggering a wave of losses for banks and investors. The other concern is that officials do not know exactly who owns a significant portion of this debt.

Regulators in the United States and Europe have been sound the alarm on leveraged loans – a loose term that refers to junk bonds and loans that have a higher risk of default. Businesses sometimes stuff themselves with this type of debt to acquire other businesses. Private equity firms also use billions of dollars in debt to buy out state-owned companies and, ideally, to beautify them and make them more competitive.

Financial engineering can also play a role. About a quarter of these risky loans are held by secured loan bonds (CLOs), according to the Financial Stability Board (FSB). These types of vehicles look like those who bought subprime mortgages before the 2008 credit crunch, but they hold business debt instead of mortgages.

You can think of CLOs as a type of investment fund. They raise money by issuing bonds and investing the proceeds in junk loans. Some of the bonds they issue are paid first and take priority over others which are riskier and will not be paid if the underlying loans default. The riskier the bonds, the more they yield.

Again, there isn’t a lot of data on who invests in CLOs. These vehicles hold about $ 744 billion in risky debt, and watchdogs don’t know who owns about 14% of the securities they issue.

Banks are the largest holders of leveraged loans, with more than 40% of the market on their balance sheets, according to FSB data. In some ways, this is a good thing. These institutions were at the epicenter of the last financial crisis and have been capitalized to help them resist defaults. They undergo intensive testing by regulators to make sure they are healthy. Officials have a pretty good idea of ​​what’s going on inside the banks and the level of risk they’re taking.

“Although banks’ exposures to leveraged loans and CLOs are significant, their risk management and measurement practices have improved since the financial crisis, and their capital and liquidity positions have been strengthened,” said the FSB said in a report last month.

It’s a safe bet that the next panic will not start within the banking system. Instead, experts believe it will take place somewhere in the financial shadows, where there is less transparency.

Investment funds and insurance companies are the second largest holders of high-risk corporate debt, according to FSB data; combined with banks, these three groups account for around 80% of leveraged loans.

The biggest concern could be what the FSB calls “certain other non-bank financial intermediaries”. Regulators aren’t sure who they are, but those parties likely include pensions, hedge funds, sovereign wealth funds, and private investors. These entities probably hold the riskiest portions of the debt, although officials admit that “this has not been confirmed by data.”

This is important for everyone because heavily indebted companies are more vulnerable when the economy stumbles: “These companies are likely to reduce investment and employment, which could further worsen an economic downturn,” said the FSB.

How did we get here?

It seems a little crazy to talk about financial engineering and risky debt a little over 10 years ago since the last credit crunch that took center stage. This is partly due to central banks. The US Federal Reserve and the European Central Bank have taken unprecedented action to cut interest rates, forcing investors, from hedge funds in London to retirees in Iowa, to take ever more risk to earn adequate returns .

Finally, there are signs in some economies that the outlook for middle-class workers, hit hard by the latest economic plunge, is improving. Policymakers in Washington and Brussels have been reluctant to do anything that could cool the economy as a tighter job market puts more money in the pockets of many workers.

Ten-year US government bonds return less than 2%, while equivalent German yields are negative. About $ 15 trillion in bonds have negative yields, according to the IMF. Investors resorted to taking more and more risk, which allowed for many questionable behaviors.

In the leveraged loan market, this behavior includes a wave of buybacks that could culminate with the biggest buyout in history: Private equity firm KKR could find a way to privatize drugstore chain Walgreens Boots Alliance , according to Bloomberg. The deal could be funded by over $ 50 billion of junk debt.

Some private equity firms have also taken their portfolio companies into debt and rewarded themselves with dividends, instead of investing in those firms, according to Moody’s Investor Service. With markets inundated with money, investors lend money while in return getting weaker protections called covenants.

The global economy does not have to suffer significantly for these loans to become a problem. A downturn half as severe as the 2008 collapse could put some $ 19 trillion in debt at risk, meaning corporate profits are not enough to cover interest costs, according to the IMF. That’s 40% of global corporate debt in major economies.

The IMF has some suggestions on how to deal with the glut of risky bonds and loans. Currently, some tax codes encourage companies to go into debt, for example. Revised tax policies could slow this debt frenzy. Another key suggestion is increased transparency regarding non-bank owners of leveraged loans, where regulators are often in the dark.

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