Fed Sounds Alarm on Looser Leveraged Loan Terms

A Federal Reserve official today sounded a warning about “material loosening” of terms, as well as insufficient risk management, in the leveraged loan sector. Speaking at an industry event in New York, Todd Vermilyea, a senior official in the Fed’s supervision and regulation division, identified three areas of concern in the $1.3 trillion leveraged loan sector, which accounts for about 29 percent of the $4.5 trillion syndicated credit market tracked through the interagency Shared National Credits program.

Specifically, he noted recent growth in “EBITDA add-backs,” which add expenses and cost savings back to earnings and which he said “could inflate the projected capacity of the borrowers to repay their loans.” Vermilyea also flagged “covenant-lite” loans, which do not contain financial performance safeguards for the lenders and which he called “widespread”, and incremental facilities, which allow additional borrowing of equal seniority to existing bank loans.

The 2017 SNC report highlighted both of these as weaknesses examiners had observed in underwriting. In 2017, leveraged loans accounted for 64.9 percent of all special mention commitments (which are non-classified commitments that examiners flagged for concern), as well as majorities of all classified assets in the SNC portfolio. That review noted that nonbanks owned 56.1 percent of all special mention and classified credits — down from 60.8 percent in 2016 — while U.S. banks owned 25 percent.