Regulators Warn On Risks Of Leveraged Loans

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency have issued joint supervisory guidance on leveraged lending.  It remains to be seen how this guidance may affect private equity groups and acquisition financing.  According to the Wall Street Journal, Wall Street sold a record $78 billion of leveraged loans in February alone, citing statistics of S&P Capital IQ LCD. The surge of deals was 10% higher than the pre-crisis record of $71 billion issued in February 2007.

According to the regulators, before the financial crisis, the volume of leveraged credit transactions grew tremendously and participation by non-regulated investors willing to accept looser terms increased. While leveraged lending declined during the crisis, volumes have since increased and prudent underwriting practices have deteriorated. The regulators believe some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders’ recourse in the event of weakened borrower performance. In addition, capital and repayment structures for some transactions, whether originated to hold or to distribute, have been aggressive. The regulators also believe management information systems at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis.

The guidance focuses attention on several key areas, including the following:

  • Establishing a sound risk-management framework: The agencies expect that management and the board of directors identify the institution’s risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes.
  • Underwriting standards: An institution’s underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower’s capital structure is sustainable, regardless of whether the transaction is underwritten to hold or to distribute.
  • Valuation standards: An institution’s standards should concentrate on the importance of sound methods in the determination and periodic revalidation of enterprise value.

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