Banks Stand Behind Shadowy Junk-Loan Market as Risks Mount, S&P Says

To hear Federal Reserve Chairman Jerome Powell talk of it, U.S. banks don't have a lot to worry about from the recent surge in loans to companies with junky credit ratings. Ever since the financial crisis of 2008, he says, most of those loans have come from lenders outside of the regulated banking system.

"That market has evolved really significantly since before the crisis," Powell said at a press conference in September. "And, you know, the banks take much less risk than they used to."

But a new report from Standard & Poor's shows that banks often stand behind the shadowy, less-regulated lenders -- through underwriting commitments, credit lines for borrowers and off-balance-sheet funding facilities for mutual funds and other investment vehicles that eventually buy the loans. Junk-rated loans are those that are regarded as below investment grade, indicating the borrowers are at a higher risk of being unable to repay the money in an economic downturn.

The biggest U.S. banks, including JPMorgan Chase & Co. (JPM) , Bank of America Corp. (BAC) and Citigroup Inc. (C)  are all at risk, primarily through "exposures" built up via their Wall Street underwriting operations, according to S&P. Many of the junky loans go to fund corporate takeovers by private-equity firms, which are big clients of the banks.    

"Banks are not immune to problems in this market," the S&P analysts wrote in the report. "We don't have enough data to precisely calculate the total exposure, but we believe it is likely at least a few hundred billion" dollars. 

S&P's report come as the International Monetary Fund and other officials have warned of increasing risks in the market for junky loans, known in the delicate industry jargon as "leveraged lending." In October, the Bank of England noted that the market bears hallmarks of the subprime mortgage frenzy in the years prior to the financial crisis of 2008.

The amount of outstanding junk-grade loans has more than doubled in the past five years to about $1.3 trillion, surpassing the historically far-deeper market for junk bonds. The concern is that an economic downturn -- or rising interest rates -- could lead to an increase in debt defaults in the fast-growing market. 

Demand for the risky loans has been stoked by the past decade of ultra-low interest rates, after central banks in the U.S., Europe and Japan moved to ease monetary conditions following the 2008 financial crisis. Although the Federal Reserve has been raising U.S. rates since late 2015, investors are still clamoring for the high-yielding investments. 

And even by the low standards of the junk-loan market, the underwriting quality has deteriorated, IMF officials wrote last week in a post on the organization's website.

"With interest rates extremely low for years and with ample money flowing though the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun," the IMF officials wrote. 

U.S. Senator Elizabeth Warren, a Massachusetts Democrat who sits on the chamber's banking committee, wrote last week in a letter to Powell and other regulators that she was concerned about the creeping risks in the leveraged-loan market. Regulators are not taking significant enough actions to protect the financial system, she wrote.

"I fear that continued growth in leveraged lending, along with the steady degradation in loan terms, creates significant risk to the financial system and the American economy," Warren wrote.  

Many leveraged loans are bought by mutual funds, investment banks or other investors who package them into bonds called "collateralized loan obligations," or CLOs -- similar to the subprime-mortgage-backed securities that were at the heart of the 2008 crisis.

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