Focus on Leverage Lending Risks

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What is Leveraged Lending?

The term “Leveraged Lending” in the financial services sector stands for an unusually high amount of money that an organization wants to borrow to carry out a business project. According to books, Leveraged Lending refers to the funds borrowed for major buyouts, significant acquisitions, or large recapitalizations. Compared to a company’s usual transaction records or finance ratios like that of the debt-to-asset, debt-to-cash, or debt-to-net-worth, leveraged loan amounts can be notably exceeding.

What are the possible systemic risks to leveraged lending?

Leveraged finance comes with many risk factors. These include:

  • The finance bodies that handle leveraged finance are commonly, but not always, non-bank entities like Collateralized Loan Obligations (CLOs) and Mutual fund providers. It means that, unlike authorized banking entities, these bodies are not subject to listed requirements like liquidity and other banking regulations.

  • The main factor posing a systemic risk to your leveraged lending from non-bank entities is the unenforceability of the guidelines set for Federal Bank Regulatory bodies. These include establishing a strong risk-management framework, well-defined underwriting standards, and realistic risk-rated leveraged loans.

  • How CLOs work and trade may not always be transparent for an outsider. Often very limited information is available about CLO investor relations and trading operations. It makes access to and management of potential risks difficult, increasing the tranches of risk per transaction.

  • Often, the repayment of a loan depends on the security that there will be an anticipated rise in profits from the project taken up. In leveraged lending, this expectation, based on complete reliance on revenue growth, becomes risky because the economy may experience an unforeseen slowdown. If the organization fails to service this loan, the consequent corporate default that follows will be larger than that seen during recent recessions.

  • With an increase in leveraged finance, covenant-lite transactions became common. There were fewer and more flexible restrictions on collateral, income standards, and repayment terms than the traditional loan system through a covenant. The risk in this practice is that there will be a repricing in the case of violation of any condition of a covenant-lite transaction, leading to multiplied credit risk.

  • The underwriting standards of the issuance of loans that determine how deserving a candidate or organization is for a particular amount of loan, given the current circumstances, have weakened for CLOs and CDOs. The price risk accompanying leveraged underwriting lending is higher than usual because any change in the investor’s plan-of-action can impact the originator’s capability to sell down positions as planned.

But is the risk always there?

The US’s leveraged loan lending market gained a return of 3.12% in 2020 despite an unexpected phase of turmoil and volatility. Although there are many reasons for leveraged loans to be risky, here are a few points that support this growth of the market in the US and suggest the otherwise:

  • The size of the market dealing with leveraged funding is small when compared to the size of the market dealing with corporate finance and its debt system.

  • Since the 2007/2008 global financial crisis, underwriting standards of bank bodies engaging in leveraged lending have become more elaborate and stringent for amortization, covenant protection, and the borrower’s repayment capacity.

  • Before lending out any amount of money to any borrower, leveraged or otherwise, banks always keep in check their financial buffers, such that they can bear a non-repayment loss up to a certain extent.

  • CLOs are established stable sources of funds for companies because of their long-term loan plans. It means they have well-planned rulebooks by which they operate and can manage leveraged finance.

  • Even though most of the systemic risk associated with leveraged finance falls outside the federal banking system’s domain, all leveraged loan activities are constantly being monitored by federal agencies who assess and mitigate credit risks as encountered.

  • Despite the analyzed risk that comes with leveraged lending, the deterioration of credit standards for leveraged funding, and the weakening of strict supervision of loan covenants, such loans’ credit performance has remained notably solid.

Conclusion 

The detailed assessment of risks posed to leveraged loan lenders and their management shows many unavoidable risk-pits in the system. Borrowers that go overboard in terms of the amount of leveraged loan taken are highly susceptible to non-repayment since any slowdown in profits will greatly impact their funds.

Non-banking entities typically mitigate the risks related to leveraged finance through portfolio diversification and longer investment horizons. But the termination of risk control rules for open-market CLOs implies that leveraged lending will pose a higher risk to banking agencies. In terms of the risks posed and how to manage them, the leveraged lending market will always remain a topic of discussion.

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