‘Leveraged lending’ continues as concern, with growth up, underwriting down

Notes CRA reform should 'strengthen ecosystem'

Excesses in corporate debt markets – which have seen “sizable growth” – could amplify adverse shocks and contribute to job losses, a member of the Federal Reserve Board told a House subcommittee Wednesday.

She also said reform of rules implementing the anti-redlining Community Reinvestment Act (CRA) should strengthen the structure of the implementing rules.

In testimony before the consumer protection and financial institutions subpanel, Gov. Lael Brainard said policy should aim to moderate financial vulnerabilities that are likely to materially exacerbate an economic downturn, leading to deeper declines in output and higher levels of unemployment.

“Over-indebted businesses may face payment strains when earnings fall unexpectedly, and they may respond by pulling back on employment and investment,” Brainard said in prepared testimony before the subcommittee, which held a hearing on financial stability issues.

She added that a slowdown in economic activity lowers investor demand for risky assets, raising spreads and depressing valuations. “As business losses accumulate, and delinquencies and defaults rise, banks are less willing or able to lend,” she said. “This dynamic feeds on itself, potentially amplifying downside risks into more serious financial stresses or a downturn.”

The Fed governor also noted in her testimony that recently there has been sizable growth in leveraged lending, “accompanied by a notable deterioration in underwriting standards.” She said net issuance of leveraged loans to risky borrowers grew rapidly last year and boosted leveraged loans outstanding to a level exceeding $1 trillion overall. But, she said, the pace of issuance has slowed more recently as the interest rate environment has shifted.

“While leveraged loans have traditionally had important investor protections, covenants for leveraged loans issued in the past few years have weakened dramatically, and they often include features that increase opacity and risk,” she told the subcommittee.

She acknowledged that, so far, the default rate on leveraged loans has been at the low end of its historical range, with corporate credit conditions favorable, low interest expenses, and low expected default rates.

However, she said, “if spreads rise sharply or economic conditions deteriorate significantly, we could see downgrades, refinancing challenges, rising delinquencies and defaults, and losses to investors.”

In other comments related to reform of rules implementing the anti-redlining Community Reinvestment Act (CRA), during questions and answers with members of the subcommittee, Brainard told Rep. Scott Tipton (R-Colo.) that the Fed is working “diligently with the OCC (Office of the Comptroller of the Currency),” which has issued a request for comments on reforming the rules, and with the Federal Deposit Insurance Corp. (FDIC) about reforming the rules.

Brainard, who serves as the point person on the Fed Board for community reinvestment issues, said it would be her preferred outcome that all of the agencies, working together, would find an approach that is responsive to the comments received but that “really does strengthen the ecosystem on CRA.”

“I wouldn’t want to do anything that would harm that ecosystem because our community banks, community development organizations, large banks are all generally committed to the CRA and want to see it improved, but not disrupted in a way that might lead to uncertainty about their ratings,” she said.

Financial Stability: Testimony of Gov. Lael Brainard

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