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COLLAPSE FEARS? $1.6 trillion in risky ‘leveraged loans’ are overhanging the global economy

An art installation titled “Hang On a Minute Lads, I’ve Got a Great Idea” by British artist Richard Wilson — at The Peninsula hotel in Hong Kong, in 2015 — is based on a scene from the movie “The Italian Job”. REUTERS/Bobby Yip

  • The total of corporate leveraged loans has hit $1.6 trillion globally, far exceeding the records set prior to the crisis of 2008.
  • The loans ballooned after the Trump Administration reversed a stricter Obama-era policy discouraging high leverage.
  • Now, leverage is increasing, while underlying covenant quality is decreasing.
  • The US Federal Reserve, the Bank of England and the Reserve Bank of Australia have all sounded the alarm over the loans. 

It is only October and already the UK economy has set a dubious new record for the year: Leveraged loans to British companies have hit about £40 billion ($52 billion), according to the Bank of England. Prior to the financial crisis, new issuances of such loans only totalled £30 billion ($39 billion).

BOE leveraged loans in the UK Bank of England

Britain’s stock of risky corporate debt is part of a trend. Globally, leveraged loans have hit $1.6 trillion, according to Institute of International Finance:

IIF leveraged loans 2IIF

Central banks are starting to worry that the corporate world may have taken on too much debt, and that the stock of risky debt overhanging the global economy might start to behave the way sub-prime mortgages did prior to 2008.

The Bank of England recently suggested that leveraged loans might become a bigger problem than sub-prime mortgages were: “The Committee is concerned by the rapid growth of leveraged lending, including to UK businesses,” the BOE’s Financial Policy Committee said recently. “The global leveraged loan market is larger than – and growing as quickly as – the US subprime mortgage market was in 2006.”

The Reserve Bank of Australia has the same concerns.

The amount of “leverage” — the multiples in debt that companies are getting into — is growing, too.

“If you look at leverage ratios, they are getting riskier because they are getting higher. Obviously, as a company takes on more debt it’s a riskier proposition than a company that takes on less debt,” said Marina Lukatsky, a director at the Leveraged Commentary & Data unit of S&P Global Market Intelligence, in a conversation with Business Insider.

In 2013, the “issuance” of new leveraged loans peaked at $607 billion. But regulators under President Obama frowned publically upon excess leverage, and the market declined through 2015 to a low of $423 billion. After President Trump took office, however, his appointees told the banking sector that they were going to be less strict about loan leverage. In 2017, new loan issuance went back up, to $650 billion — a new record.

The total of new leveraged loan issued last year exceeded pre-crisis levels by about $100 billion

Put simply, leveraged loans are given to troubled companies who can’t get access to cheaper credit via a normal loan from a bank or by raising an investment-grade corporate bond. The “leverage” comes from private equity (PE) groups, who invest their own money in return for a chunk of equity in the company, in combination with the loan. The rest of the funding may be provided by banks.

The loans are then bundled and sold on private markets in the form of collateral loan obligations — bundles of debt that can be bought and sold like mortgages. The PE groups are hoping that the equity and debt investments they make are enough to turn the companies around. When that happens they can sell their stakes at a premium.

Investors have poured money into leveraged loan products because the companies who take them are required to pay higher rates of interest than they would get by holding government bonds.