The Federal Reserve is sounding alarms on the growing risks from loans to companies with poor credit ratings. So are the International Monetary Fund, Standard & Poor's, Fitch Ratings and U.S. Senator Elizabeth Warren of Massachusetts, a top Democratic presidential candidate.
"Someone's going to get hurt there," JPMorgan CEO Jamie Dimon said of the junk-loan market on a conference call last month. "That's not our concern."
Loans in the U.S. to companies with junk-grade credit ratings swelled by 15% last year to a record $1.3 trillion, Fitch said this week in a report. And on Jan. 25, bank regulators warned in a report that underwriting standards for the loans are deteriorating, with "weakened transaction structures" and more borrowers qualifying based on projected revenue or "anticipated cost savings," instead of their current level of earnings.
The surge is fueled by investors' hunt for high-yielding assets that would theoretically be immune from fast-rising interest rates -- as has often happened historically when unemployment is low and the economy is growing. Junk-grade corporate loans fit the bill, since interest payments are usually tied to variable rates. Bonds, by contrast, often come with fixed coupon payments that would be worth less to investors if interest rates rose.
The junk loans are known as "leveraged" since they allow borrowers to reap a multiple of the returns they would get from an investment without any debt. The analogy is to a lever that's used to lift a heavy weight, with a tiny force applied to the other end.
In the past, the loans were typically shared among banks globally. Changing market dynamics and stricter financial-industry regulations since the 2008 mortgage crisis have prompted the banks increasingly to sell off the loans to investment firms, which in turn package the rich-yielding assets for sale to their own customers.
Executives at Bank of America Corp. (BAC) , the second-biggest U.S. lender, disclosed last month that the bank makes about $1 billion a year of revenue from various activities linked to junk-grade loans, or about 1% of overall revenue. But they argue that the risks are passed along like a hot potato.
"We market and move them out and it's gone," Bank of America CEO Brian Moynihan told Wall Street analysts on a Jan. 16 conference call.
So what's the problem? The concern is that companies with junk loans wouldn't be able to afford their debt payments if interest rates surged -- especially if such an occurrence coincided with an economic downturn that hurt sales, reducing the cash that would otherwise be available to satisfy creditors.
If that happened, the thinking goes, the investment firms might seek to sell the assets en masse, flooding the market and sending prices plunging. Losses could mount for big pension funds that invest money on behalf of retirees, often with financial guarantees from federal and state governments. Banks, which still underwrite many of the loans, could get stuck with them if the markets freeze up, and potentially face major fines from regulators or lawsuits from investors trying to recoup their losses.
In October, the Bank of England noted that the leveraged-loan market bears hallmarks of the subprime mortgage frenzy in the years prior to the financial crisis of 2008.
Yet don't go looking for trouble at Goldman Sachs Group Inc. (GS) , a top arranger of corporate buyouts financed with junk-grade loans. In 2007, Goldman took part in the $45 billion buyout of a Texas electric utility, at the time the biggest-ever deal financed with leveraged loans; the utility filed for bankruptcy in 2014.
"If you look more broadly at our risk exposure in terms of leverage lending and the like, it remains small on relative terms," Goldman CFO Stephen Scherr told investors last month.
Blackstone, the biggest publicly traded private-equity firm, has capitalized on the growing popularity of the loans, relying on the market to finance its purchases of private companies and, in recent years, buying up the high-yielding assets to stuff into investment funds.
With the economy growing and interest rates stable, everything is fine so far, according to Blackstone. That's despite a panic in the junk-loan market in December that left prices for the assets at about 95 cents on the dollar, down from about 97 cents at the start of the year, according to data provider IHS Markit (INFO) . Prices recovered somewhat in January.
"Despite investor concerns around the leverage loan market, in particular, we haven't seen a deterioration in the credit quality of our holdings, and our default rates remain close to zero," Blackstone Chief Operating Officer Jon Gray said on a Jan. 31 conference call.
Indeed, distress in the market is hard to perceive right now because the pace of loan defaults is currently so low. According to Fitch, just 1.7% of junk-grade loans defaulted last year, down from 2.4% in 2017. This year, the ratings firm projects the loans will perform even better, with a default rate of just 1.5% -- thanks to benign economic conditions.
"The economy has been relatively strong, so you don't see as much deterioration in the credit quality," Dio Mejia, an analyst who tracks the leveraged-loan market for Standard & Poor's, said in a phone interview.
The key fear among regulators and the IMF is a repeat of the 2008 financial crisis, which was triggered by a decline in home values and a spike in defaults on loans to homebuyers with tarnished "subprime" credit. In the preceding years, banks and other firms eagerly underwrote subprime mortgages because of the rich interest payments.
Wall Street brokerage firms like Bear Stearns (now part of JPMorgan), Merrill Lynch (now part of Bank of America) and Lehman Brothers (now part of London-based Barclays Plc (BCS) ) bought the subprime mortgages and packaged them into bonds. Those bonds were in turn packaged into new bonds called "collateralized debt obligations," or CDOs, which in turn were packaged into yet another class of bonds known as CDO-squareds.
Before it all melted down, Wall Street executives raked in fat bonuses and shareholders pocketed juicy dividends. Eventually, the entire financial system nearly collapsed, saved only by hundreds of billions of bailout money from the Treasury Department and more than $1 trillion of secretive emergency loans from the Federal Reserve.
A similar frenzy is happening now with junk loans. The end product is a type of bonds known as "collateralized loan obligations," or CLOs. New York-based Blackstone is the biggest manager of CLOs, overseeing about $28 billion of the investment vehicles, according to Creditflux, a publication that tracks the industry.
Citigroup Inc. (C) , the third-largest U.S. bank, whose mortgage investments before the crisis were so disastrous that it eventually needed a $45 billion government bailout, was the biggest arranger of CLOs globally, according to Creditflux.
Mark Mason, Citigroup's incoming chief operating officer, told analysts on Jan. 14 that the bank provides "warehouse lending" to CLO managers, a type of financing for junk loans that's in place until the bonds can be packaged and sold. The exposure is limited to $5 billion, Mason said.
"There are some structural protections that are in place that have been enhanced since the crisis," Mason said on a conference call. "We feel pretty good about where we stand at this point."
Michael Paladino, a managing director at Fitch, recalls that the default rate for leveraged loans stood at an undistressing 0.2% in 2007, just before the financial crisis hit. Within two years it jumped more than 50-fold to 10.5%.
"At some point the overall cycle is going to turn negative, but when that occurs is the $64,000 question," Paladino said in a phone interview.
Although, it's more likely to cost billions.