Comparing the recession of 2001 and the recession of 2007-2009 reminded economists of an old lesson: A crash of asset prices in the stock market or housing can be a nasty hit for an economy, but when problems arise where many debts aren\’t going to be repaid in full or on time, the shock to the financial system and the economy can be much worse. For example, one study of the Great Recession found that about one-quarter or one-third of the decline in output was because of the fall in housing prices, while about two-thirds or three-quarters of the decline was related to how problems related to excessive debt worked their way through the financial system
Leveraged loans are loans made to highly indebted companies and are typically originated by commercial banks and then syndicated to nonbank investors, including special-purpose vehicles such as collateralized loan obligations (CLOs), private equity funds and other stand-alone entities. The size of the syndicated leveraged loan market, which is primarily made up of nonfinancial corporate borrowers, has increased from $0.6 trillion at the end of 2008 to $1.2 trillion at year-end 2018. Much of this increase has occurred to fund corporate acquisitions and private-equity-backed transactions.
In addition to the syndicated leveraged loan market, there is also a direct lending market for leveraged loans in the U.S. This market primarily involves nonbank financial firms—such as asset managers, private equity funds, business development corporations (BDCs), hedge funds, insurance companies and pension funds—lending directly to smaller, mid-market companies. While it is difficult to obtain precise information on the size of this market, Standard and Poor’s (S&P) estimates that the amount of outstanding leveraged loans in the U.S. direct lending market has grown significantly over the past several years and now likely exceeds several hundred billion dollars. …
The U.S. CLO market has grown from roughly $300 billion at the end of 2008 to $615 billion at the end of 2018. However, it is important to recognize that CLO loan-credit quality today is estimated to be somewhat weaker than 10 years ago.
S&P estimates that in 2018, CLOs and loan mutual funds purchased approximately 60 percent and 20 percent, respectively, of syndicated leveraged loan volumes. It is estimated that less than 10 percent of new issuance was purchased by banks in the U.S. The remaining volumes were purchased by insurance companies, finance companies and others. Because CLOs are today the largest buyer of these syndicated leveraged loans, disruptions to CLO creation could increase the likelihood that leveraged loans remain on bank balance sheets, which could, in turn, limit the ability of affected banks to extend credit during periods of stress.
The US corporate debt situation is by no means foreordained to turn into a disaster. But by tightening up on regulation of banks, much of the action in US corrporate borrowing has been shifting into bond markets, the leveraged loan market, and collateralized loan obligations. There are plenty of echoes here of what made a bad economic situation so much worse in 2008, and plenty of reasons for financial regulators to watch carefully as this pot boils.For some earlier comments on these themes, see:
- \”Corporate Debt and Leveraged Loans: Financial Snags Ahead?\” (September 21, 2018)
- \”The Dramatic Expansion of Corporate Bonds\” (June 21, 2018)