History showing pauses in rate hikes are an acknowledgment of a slowing business/profit cycle

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Even Banks Are Telling the Fed There’s Not Enough Leveraged Loan Regulation

NEW YORK/ST. LOUIS (Reuters) – Bankers, executives and investors are warning Federal Reserve officials behind closed doors that record leveraged lending to companies from lightly-regulated corners of Wall Street could make any economic downturn harder to manage.

With the second-longest U.S. expansion in its advanced stages, the worry is that a key part of the credit market could be particularly vulnerable to a slowdown, as highly-indebted companies face a greater risk of default.

Some of those involved in the debate who spoke to Reuters expressed frustration that the Fed is not taking the risk seriously enough.

“There is a sense at the Fed that it needs to watch this area, leveraged credit, but it’s still in the infancy and it’s unclear how far will it go,” said an economist familiar with the Fed’s efforts.

In a worst-case scenario that would faintly echo the financial crisis a decade ago, the defaults could worsen any downturn by destabilizing big non-bank lenders, such as private equity firms and hedge funds, and hitting employment across U.S. industries. Leveraged loans are typically made to already indebted firms with low credit ratings, and the concern is that the loans would be difficult to either collect or resell in a downturn, putting both the borrower and lender at risk.

The US economy is strong. Three signs it won’t last

1. Risky corporate borrowing

Historically, peaks in corporate borrowing have been followed by recessions. In the first quarter of 2018, US companies held a total of $29.6 trillion in debt, more than ever before. More importantly, that figure as a share of the economy is only slightly off its all-time peak in the last quarter of 2017.

For almost the past decade, that debt has been essentially free, as the Federal Reserve kept interest rates near zero to spur growth. Companies used the money to invest in equipment and research, as well as to gobble up other companies and buy back their own stock.

Now, however, interest rates are on the rise again, which could mean that owing lots of money will get more expensive. And it’s not just the quantity of the debt outstanding — it’s also the quality.

In 2017, according to a recent note by Citibank, $1.6 trillion in new debt issued in the United States went to borrowers with less-than-stellar credit ratings. That’s the highest since the years leading up to the 2008 financial crisis, and 2018 is on track to almost match it.

Those leveraged loans have floating interest rates, and risky corporate borrowers could have a hard time making payments if rates rise too fast. That raises the prospect of larger and more widespread bankruptcies if there’s an economic shock — andresearch shows that companies that hold more debt end up laying off more people during recessions.

That’s why everyone from Senator Elizabeth Warren to the IMF has raised the alarm about the rise of leveraged lending, likening it to the deterioration in mortgage underwriting standards that preceded the last financial crisis.

“The regulators have not taken preventive action to prevent the buildup of risk,” says Richard Berner, who until last year ran the Treasury Department’s Office of Financial Research. “So they have to think about what they do when bad things happen.”

2. The return of ‘buying more house than you can afford’

In the years following the financial crisis, banks became extremely careful about mortgage lending, often to the point where even credit-worthy borrowers had a hard time getting loans. Gradually, those standards have eased up — but it’s not clear whether they’ve gone too far.

One worrying indicator: The average debt-to-income ratio for mortgages insured by the Federal Housing Administration, which makes up about 22% of the housing market, is now at its highest level ever.

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Much of the increase is driven by the fact that limited inventory has made housing in general much more expensive, while wages haven’t kept up.

“Owning a home and having a high debt-to-income ratio makes a lot of sense if the alternative is renting and having all your income go towards rent,” says Ed Golding, a former head of the FHA who is now a fellow at the Urban Institute.

This isn’t necessarily a problem as long as borrowers are on a sound financial footing, which lenders now have to confirm by verifying that applicants have sufficient collateral and a stable income stream. So far, those fundamentals continue to look strong, and default rates remain very low.

“If you look at requirements they have from an assets perspective, back in the day, in 2006 and 2007, you could write it on a napkin and get a mortgage loan,” says Leo Loomie, senior vice president with the mortgage monitoring and compliance firm Digital Risk. “You cannot do that anymore. There’s a ton of data control that wasn’t in place 10, 12 years ago.”

But there are potential red flags in the FHA’s annual report, including a dramatic rise in cash-out refinances that allow homeowners to tap the equity in their homes for money — essentially, the return of homeowners using their properties as ATMs as home values rise. The FHA also voiced concern about the proliferation of down payment assistance programs, which are associated with higher rates of delinquency.

And housing isn’t the only reason consumers are taking on debt. Total credit, including student and auto loans, has risen far above its pre-recession peak, according to the Federal Reserve Bank of New York — creating a problem if the job market softens.

“The American public is more leveraged than I would like,” says Golding.

3. Unemployment is lower than it’s supposed to be

The near 50-year low in the US unemployment rate, which stood at 3.7% in October, is a great thing for many reasons. It’s finally starting to fuel wage increases. It creates opportunities for workers who might otherwise be passed over by prospective employers, such as disabled people and those with criminal records. It means that the consequences of being laid off, which happens even in the best economies, might not be as dire.

But if history is any guide, the United States can’t sustain the current level of unemployment for very long. Right now, it’s well below what economists call the “natural rate” of unemployment, which is a level that accounts for workers moving between jobs.

 

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