The results of the review, which covers all loans of at least $20 million provided by three or more institutions, will be scrutinized for evidence of any impact that the stricter stance taken by the regulators on leveraged lending standards this year have had.
When Euromoney spoke to bankers in New York during the summer, the impression was the guidelines have had a limited impact.
“The OCC guidelines have had a modest impact,” says one senior DCM banker in New York. “We have seen highly levered deals that the banks won’t touch, but they are being done by others.”
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| The guidelines were left vague. There has been some verbal guidance, but everyone expects further clarification on the heels of the annual lending reviews Richard Zogheb |
The guidelines restrict bank lending to deals with more than six-times leverage.
The September 2013 SNC survey criticized 42% of leveraged lending in the market, triggering the issuance by the regulators of stern letters to the banks telling them to get their houses in order.
Several high-profile deals subsequently saw OCC-regulated banks replaced by foreign banks or broker dealers, triggering widespread concern about the impact the new rules will have on what is a lucrative business line for the banks.
When some of the original lenders to KKR’s $1.6 billion leveraged buyout (LBO) of Maryland-based landscape management company Brickman in November 2013 did not appear on the ticket for a subsequent $725 million loan to back the purchase of ValleyCrest Companies, it was seen as a sign of things to come.
The original LBO, which had a leverage multiple of 6.5 times, was lead managed by Morgan Stanley, but the loan for the ValleyCrest acquisition was led by broker dealer Jefferies and Credit Suisse.
One leveraged finance banker Euromoney spoke to emphasized how careful the bank was being. “We are very careful to only do things that we know will pass credit,” he says. “For existing deals, we try to make sure that the new transaction improves the credit.”
Big fear
The big fear among leveraged finance banks on Wall Street is that they will have to cede ground in leveraged finance to non-OCC-regulated banks, foreign banks and non-banks as a result of the tougher guidelines.
It isn’t hard to fathom why. According to a recent report published by Keefe, Bruyette & Woods, syndicated leveraged lending generated $14.3 billion fees to the banks in 2013 and by June had generated $4.4 billion in 2014.
An examination of league-table positions at the beginning of September suggests such concerns are not unfounded. According to Dealogic, the top-ranked US marketed LBO bookrunners from January to September were Credit Suisse, Deutsche Bank and Barclays – all European banks.
The equivalent ranking for January to September 2013 has Barclays in the top spot followed by Citi and JPMorgan. JPMorgan slips from third to fourth this year while Citi slips out of the top 10 altogether. Jefferies moves up from 10th to ninth in the ranking for 2014.
Foreign banks in the US are regulated by the Fed, which has applied the new guidelines less stringently than the OCC. The latter has taken a tougher stance with the domestic lenders under its jurisdiction.
It seems premature to conclude that the OCC guidelines are the sole cause of this reshuffle at the top: the three European lenders have always been strong in US leveraged lending. And anecdotal evidence suggests application of the new rules has been patchy at best.
“The OCC guidelines haven’t been implemented by the banks 100%,” claims one large US-based asset manager. “There has been some effort but it has been sporadic. The banks are trying to figure out how aggressive they can be.”
It is for this reason the market awaits the SNC survey outcome with such interest. If the results show little has changed, despite the regulators’ firm rhetoric, the ante might be upped yet again.
“The guidelines were left vague,” says Richard Zogheb, co-head of capital markets origination at Citi in New York. “There has been some verbal guidance, but everyone expects further clarification on the heels of the annual lending reviews.”
Tougher stance
A tougher stance could see business move not only to broker dealers but also to other non-bank lenders. Zogheb believes, however, that the threat to the banks from such lenders is being somewhat overstated.
“Hedge funds and asset managers are looking at the OCC guidelines as an opportunity,” he says. “But this business requires an enormous amount of capital, a distribution network and expertise.”
On the face of it, the regulators’ aim of reducing risky lending behaviour in the high-yield loan market seems to have borne little fruit.
According to Brandywine Global Investment Management, the percentage of US lending that is now covenant-lite is 61.6% compared with 25% in 2007 and 7.4% in 2006. The percentage of those loans rated just single-B is 53% (32.7% in 2007, 24.5% in 2006). The volume of loans written to fund dividends and buybacks stands at $61.2 billion, compared with $38.2 billion in 2007 and $40.3 billion in 2006.
“The amount of covenant-lite debt in the US is particularly arresting, as is the amount of debt with proceeds slated for dividend pay-outs,” notes Gary Herbert, portfolio manager at the firm. “US credit fundamentals are deteriorating – at least by the headline metrics of total non-financial debt to earnings and free cash flow to debt – beyond levels that existed prior to the financial crisis.”
| Further reading |
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| Regulatory firestorm rocks leveraged finance |
The spectre of 2006 and 2007 is continuously raised in discussions as to the risk the leveraged finance market now represents. However, Zogheb at Citi argues that the market is still some considerable distance from its pre-crisis state.
“The industry did deals in 2007 that were entirely sold to hedge funds and CLOs [collateralized loan obligations] and we had 10 times the exposure that we have today – the real-money buyers were outnumbered. That is simply not happening now. Our commitments will grow but not 10-fold.”
Indeed, the extent to which covenant-lite lending should even be of concern to the market is hotly contested, with many investors unconcerned about its rise.
Russ Covode, co-lead manager on the Neuberger Berman High Yield Bond Fund, is comfortable with the protections on offer.
“We are comfortable with covenant-lite lending because covenants are the third most-important aspect of a loan,” he says. “The most important is assessing whether the company needs to exist and, second, whether you are getting paid to own the risk.
“If we get these first two right, then covenants don’t really come into play. And covenants don’t protect you from the first 10-point drop in price when a company stumbles, but they certainly become more interesting after that.”
Nervous regulators
With $527 billion-worth of leveraged loans having been written in the US during the first half of 2014, the regulators can be forgiven for getting nervous. In testimony given to the Senate banking committee on July 15, Fed chair Janet Yellen observed: “We’re seeing a deterioration in lending standards, and we are attentive to risks that can develop in this environment.”
However, if they decide to come down heavily on the banks and sharply restrict lending after the SNC results, many bankers argue they could be underestimating the negative impact on the real economy.
Some argue what is driving the regulators is a latent fear that in a further crisis all the loans will come back to the banks anyway. The question is whether that fear overwhelms concerns about pushing companies into bankruptcy.
“There are many hugely indebted corporates [largely the product of jumbo LBOs done at the height of the boom] that will never grow into their capital structure, but keeping them around saves a lot of jobs,” points out one banker. “If they are forced to file for bankruptcy, it will mean that a lot of people get laid off.”
US overdrive
If investors in leveraged loans share the regulators’ concerns about lending standards, they aren’t showing it. In a rush to pre-empt risk retention rules, the US CLO market has gone into overdrive, racking up $83.1 billion issuance by late August, surpassing the market’s 2013 total. CLOs now buy around 60% of US leveraged loans.
“The CLO market is growing and is having a real impact on the loan market,” says one banker. “However, it won’t get to where it was.
“There are two principal types of investor in the market today: loan mutual funds and CLOs. The latter definitely understand the protections that they are giving away – they know exactly what they are doing. On the retail side, investors are simply getting money into loans rapidly as protection against rate rises.”
This surge of interest in floating rate loan products has been a blessing and a curse.
“We are very careful how we manage our bank loan product,” says one portfolio manager. “There has been a lot of money flowing into loans and it can be very difficult to manage the credit cycle.
“I am guessing that the banks will take the OCC guidelines seriously now and if there is less risk associated with loans then spreads will tighten. This means that the price will go down and retail investors will lose interest, stemming some of the gargantuan inflows we have seen. This will help to stabilize the market.”
