Agencies find ‘serious deficiencies’ in leveraged loans underwriting

By Angela McDaniels

Tacoma, Wash., Nov. 7 – Federal banking agencies will increase the frequency of leveraged lending reviews in response to what they called serious deficiencies in underwriting standards and risk management of leveraged loans.

“The agencies recognize that leveraged lending is an important type of financing for the U.S. and global economies and that the U.S. banking system plays a key role in making credit available by syndicating credit to investors. However, banks must not heighten risk by originating and distributing poorly underwritten and low-quality loans,” the agencies said in a report.

Leveraged loans totaled $767 billion, or 22.6%, of the 2014 shared national credit portfolio but accounted for $254.7 billion, or 74.7%, of criticized shared national credit assets, according to the annual shared national credits review carried out by the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp. and the Office of Comptroller of the Currency.

The review also found that 33.2% of leveraged loans were criticized.

A shared national credit is defined as any loan or formal loan commitment, and asset such as real estate, stocks, notes, bonds and debentures taken as debts previously contracted, extended to borrowers by a federally supervised institution that totals $20 million or more and is shared by three or more unaffiliated supervised institutions.

A criticized asset is rated special mention, substandard, doubtful or loss as defined by the agencies' uniform loan classification standards.

Leveraged loans comprised 72.9% of shared national credit loans rated special mention in the review, 75.3% of all substandard loans, 81.6% of all doubtful loans and 83.9% of all nonaccrual loans.

Greater compliance sought

The agencies identified several areas where they said institutions need to strengthen compliance, including provisions addressing borrower repayment capacity, leverage, underwriting and enterprise valuation.

In addition, the agencies said they found risk-management weaknesses at several institutions engaged in leveraged lending including lack of adequate support for enterprise valuations and reliance on dated valuations, weaknesses in credit analysis and overreliance on sponsor's projections.

“Thirty-one percent of leveraged transactions originated within the past year exhibited structures that were cited as weak, mainly because of a combination of high leverage and the absence of financial covenants. Other weak characteristics observed included nominal equity and minimal deleveraging capacity,” the agencies said.

In particular, the agencies said transactions that “increase leverage without a subsequent increase in cash flow generation (e.g., loans used to pay dividends to equity investors) should be viewed with greater caution.”

In addition to increased reviews, the agencies are releasing answers to frequently asked questions on the guidance. The questions cover expectations when defining leveraged loans, supervisory expectations on the origination of non-pass leveraged loans and other topics.

LSTA response

In response, Bram Smith, executive director of the Loans Syndications & Trading Association, said, “Non-investment-grade U.S. companies have unique characteristics and financing needs. Recognizing the uniqueness of these borrowers, we encourage the agencies to continue to evaluate leveraged loans on [a] nuanced basis, balancing the importance of a safe system, while ensuring that credit-worthy companies are still able to access the financing they need.”

About the review

The results of the review are based on analyses prepared in the second quarter of 2014 using credit-related data provided by federally supervised institutions as of Dec. 31, 2013 and March 31, 2014.

The agencies reviewed $975 billion of the $3.39 trillion credit commitments in the portfolio. They said the sample was weighted toward non-investment-grade and criticized credits.

For leveraged loans, the agencies reviewed $623 billion of commitments, or 63.9%, of leveraged borrowers, representing 81% of all leveraged loans by dollar commitments.

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