The mortgage meltdown that caused the financial crisis was ugly, and the market underneath that meltdown was uglier.
How does the leveraged loan market stack up, and should investors be nervous?
Let's start with what leveraged lending is.
What Are Leveraged Loans? A Primer
Let's begin with a primer.
Leveraged Loans are loans made to companies that already have high levels of debt, and whose bonds may be trading at a serious discount to par value (or bond value at issuance). Therefore, the lender, often a bank, sometimes a credit fund, demands a high yield in return for taking on the credit risk.
Leveraged loans are very risky to the company.
That's because if the company can't use that debt to grow cash flow quickly, it has decelerating or shrinking cash flow and rising debt. Then, the ability to expand is compromised.
This not only puts companies at risk, but if banks are overexposed, they're at risk too.
The Economic Risk
Well, the leveraged loan market grew 20% year-over-year to $1.1 trillion in 2018, according to the Federal Reserve's most recent Financial Stability Report. That's just a touch under 5% of U.S. GDP. The share of new leveraged loans extended to distressed companies is now higher than levels reached in 2007. And those were peak levels.
This could be a serious drag on the economy, the Federal Reserve has noted in recent meetings. Even worse, the market for leveraged loans, a poor-credit product, is now larger than that of the traditional poor-credit market of junk bonds.
"The fact that the size of the leveraged loan market surpassed that of junk bonds last year also puts into perspective the damage this sector can inflict on the rest of the system," Danielle DiMartino Booth, former adviser to the president of the Dallas Federal Reserve told TheStreet.
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Could the Financial Crisis Happen Again?
Hold your horses. Yes, there's definitely risk, and this market resembles in many ways that of the toxic mortgage securities before the financial crisis. Some are even calling for more transparency in the leveraged loan market.
A lack of transparency helped create the crisis, as junk mortgage bonds were given triple-A credit ratings, which perpetuated the issuance of the loans which comprise those bonds.
Here's the catch: banks can absorb big losses way better than they could before 2008. Dodd-Frank regulations require U.S. banks to have a CET 1 ratio (a measure of capital to cover potential losses) of 4.5%, versus the 2% or below seen before 2008.
Many banks have CET 1 ratio's of above 12% now. "Even the larger banks, when you get to talking with them privately - the overall system is much safer today than it was pre-crisis," Democratic Senator Mark Warner of Virginia told TheStreet in March.
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