About two years ago the various US bank regulatory agencies (the OCC, the FDIC, and the Fed) have started pushing through the so-called Guidance on Leveraged Lending. They were alarmed at the rising leverage and weaker covenants (see post) in new sub-investment grade corporate finance transactions that involved senior loans.
US Regulators (March 2012): – Credit agreement covenant protections, including financial performance (such as debt to cash flow, interest coverage or fixed charge coverage), reporting requirements, and compliance monitoring. Generally, a leverage level after planned asset sales (i.e., debt that must be serviced from operating cash flow) in excess of 6x for Total Debt/EBITDA raises concerns for most industries.
The guidelines ultimately went into effect, as US regulators made it known that they will be watching these transactions closely. Particular emphasis has been given to the “6x” leverage cutoff that regulators view as the “danger zone”.
Bloomberg (October 2013): – The Federal Reserve and the Office of the Comptroller of the Currency sent letters to some of the biggest U.S. banks asking them to avoid arranging debt that may be classified by regulators as having some deficiency that may result in a loss, according to nine people with knowledge of the communication.
Of course a great deal of this paper is not held on banks’ balance sheets and instead sold to CLOs, traded loan funds, and other asset managers. What the regulators fear however is that a major market disruption will prevent banks from unloading this risk, resulting in “hung” deals that could jeopardize bank stability.
Recently, Deutsche Bank researchers took a closer look at how effective the Guidance on Leveraged Lending policy has been. What they found so far is that this regulatory effort does not seem to have much of an impact at all, as the percentage of loans with leverage of 6x and above continues to rise.
