US banks may be ignoring history in their search for yield. According to the Office of the Comptroller of the Currency, standards for leveraged loans have weakened over the past 18 months and yields on high-risk assets are at record lows and risk continuing to rise. These practices are similar to those seen in the years just before the 2008 financial crisis.
“Threats to business models from low rates, sluggish economic growth, and the historic volume of new banking regulations, remain high,” the OCC said in its “Semiannual Risk Perspective for Fall 2012.” This may lead banks to make riskier bets.The OCC is very worried about the rise in covenant-lite loans. The regulator has seen “noticeably more relaxed structures incorporating fewer covenants and lender protections.” The OCC said the proportion of new-issue cov-lite loans “increased to the third highest on record through the first half of 2012. While still well below 2007 levels, the quality of underwriting “remains a long-term concern,” the OCC said.
Leveraged financing has once again become a popular source of funding for acquisitions and private-equity buyouts. Demand for leveraged loans has taken off in 2012 amid low interest rates, tempting companies to borrow more money or refinance their debt. Their popularity has been driven by investors’ appetite for higher returns in a low-interest rate environment. What’s more, according to a report from Barclays, the leveraged loan market will see even more activity in 2013 as growth in the collateralized loan obligation (CLO) market will combine with chronically low rates to make loans advantageous enough to spur companies that have issued bonds this year to return to the loan market. Barclays said CLO managers will cram as many deals as they can into 2013 and 2014 before Basel III risk retention rules kick in and, possibly, shut down the market.