Virus could deal blow to leveraged loans. What's that mean for banks?

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WASHINGTON — A rollercoaster stock market. A quickly planned White House meeting with bank CEOs. Uncertainty about the next shoe to drop.

With the coronavirus outbreak spurring increasing worries about the economic fallout, there are shades of 2008 in 2020.

Which segment of the financial sector could be hardest hit, if any, is still a matter of debate. But some industry watchers say a worsening crisis could unmask the historically high levels of risky corporate debt, including leveraged loans, with a spillover effect for banks.

“We may be in an economic moment just as serious as 2008, but it's an economic moment that looks very different than 2008 in a lot of ways,” said Marcus Stanley, the policy director for Americans for Financial Reform.

As businesses have loaded up on debt in the low-interest-rate years following the 2008 financial crisis, the global leveraged loan market is estimated to be anywhere from $1 trillion to $3 trillion. Up to now, regulators have been more worried about nonbanks' steadily increasing share of that market, with the regulated financial system thought to be protected.

Many in the industry have argued that the banks would be insulated from a direct hit to leveraged loans, since most of the risk is concentrated in the nonbank sector. But there is also data that has shown that leveraged loans on banks’ books have been growing steadily in recent years.

And even if banks aren’t making these loans directly, they have invested in collateralized loan obligations — which are made up of leveraged loans — and are also exposed through prime brokerage and credit derivatives, said Erik Gerding, a professor at University of Colorado Law School. In that scenario, banks would be among multiple sectors caught in the tailwinds.

Read more: Complete coverage of the coronavirus impact

“I think the real concern is if this hits a broad enough set of industries, that the diversification that happens in the leveraged loans, and particularly in the CLO market, begins to affect a lot of different lenders and investors,” he said.

The default rate for leveraged loans has remained remarkably low — only reaching 1% in July. But the volatility in the markets stoked by the coronavirus scare has experts wondering if delinquencies are on the brink of spiking as businesses across all sectors forecast lower earnings.

Highly leveraged companies that either experience a disruption in their supply chains or reduced demand because of the coronavirus could have difficulty repaying their loans, which could result in a domino effect on the broader economy, said Gaurav Vasisht, senior vice president of the Volcker Alliance.

“The question is whether there's broader instability, whether we see a wave of defaults and downgrades, which seems more likely the longer the coronavirus is left uncontained,” he said. “If that were to happen, it would amplify losses and the key question then would be whether the large banks are strong enough not just to withstand losses, but also to continue lending.”

Still, the blow could be softened because the coronavirus emerged while default rates on leveraged loans are still low, said Richard Farley, chairman of the leveraged finance group at Kramer Levin Naftalis & Frankel. If those rates had already been ticking up, “it could very well be systemically a lot worse,” he said.

“I think there will be certain credits that don't make it. I don't think it's going to be systemic,” he said. “And I think that there's been enough central bank easing and the promise of other interventions where I think it's unlikely you're going to have a systemic problem in the leveraged lending market.”

Banks also wouldn’t be likely to face rocketing instability if default rates on leveraged loans went south, said Stanley.

“I do think [the banks] are exposed, but I'm not sure people think that it's enough exposure to bring them down or repeat 2008,” he said.

But others believe that the Trump administration’s deregulatory agenda has left financial institutions in worse shape, compared with the regulatory expansion after the 2008 crisis, to deal with a situation where they could be facing more losses.

“Unfortunately, what we've seen over the last couple of years is a chipping away at bank capital requirements. The more loss-absorbing capital banks have, the better they are at withstanding losses,” said Vasisht. “But we've seen a reduction in the strength and frequency of stress testing [and] a weakening of leverage capital requirements.”

An unpredictable event like the coronavirus is exactly why banks should have more regulatory cushions and not less, Gerding said.

“Long run, I think we may come to regret some of the weakening of those types of policies,” he said.

The worst-case scenario would be financial instability, said Vasisht.

“I think we're going to see a downturn,” he said. “But whether that downturn is exacerbated by financial instability will depend on whether the banking system is safe and sound.”

However, banks are confronting the emerging economic threat of the coronavirus “with more capital and better capital than" they had leading up to the 2008 crisis, Jaret Seiberg, an analyst with Cowen Washington Research Group, said in a note. And unlike before the financial crisis, banks now undergo rigorous stress testing, he said.

“Regulators and bankers know these risks and have planned for these risks,” Seiberg said. “It is hard for us to believe that leveraged loans could become the new subprime mortgages given this focus.”

Seiberg added that both today’s banks and today’s housing market are more stable compared to 2008 and are “better able to withstand turbulence and economic losses associated with COVID-19 than they were for losses connected to subprime loans.”

Farley says the economic impact of the coronavirus is much more likely to be a blip rather than a cataclysmic event for mounting corporate debt.

“Given the availability and extremely low cost of capital, I think all but the most highly leveraged, directly impacted businesses will sail through,” he said.

The nature of leveraged loans could also mean that any impact of rising defaults on banks could be more gradual than the events that led to the bank failures stemming from the 2008 financial crisis, Stanley said.

“For the companies themselves, the price of this debt doesn't hit them in many cases until they have to refinance, so they have to turn over their current loans. That might not be an immediate thing,” he said. “In that sense, it's sort of a slow car crash. You have more leeway to take time with addressing this problem than you would if, say, a bank was going bust.”

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