New guidance seeking to head off another meltdown could affect marginal borrowers.
Banking regulators in the US have issued new guidance on leverage lending, its first since 2001. Noting that leveraged lending has expanded rapidly since the end of the last credit crunch, the regulators now worry that the market could be setting itself up for another crisis. Leveraged borrowers may want to strike while the iron is hot.
Issued by the Fed, the OCC and FDIC, the guidance discusses the current deteriorating market conditions, noting, “…Some debt agreements have included features that weaken lender protection by excluding meaningful maintenance covenants and including other features that can limit lenders’ recourse in the event of weakened borrower performance. In addition, capital and repayment structures for some transactions, whether originated to hold or to distribute, have been aggressive. Management information systems at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis.”
Regulators have cause to be worried. First quarter new issue leveraged loan volume was the highest since the second quarter of 2007 – immediately before the credit crisis. According to Leveraged Commentary and Data, $185.2 billion of leveraged loans were issued in the first quarter.
The regulators’ guidance provides the following guidelines for lenders. Borrowers can anticipate more scrutiny in these areas:
- Establishing a sound risk-management framework: The agencies expect that management and the board of directors identify the institution’s risk appetite for leveraged finance, establish appropriate credit limits, and ensure prudent oversight and approval processes.
- Underwriting standards: An institution’s underwriting standards should clearly define expectations for cash flow capacity, amortization, covenant protection, collateral controls, and the underlying business premise for each transaction, and should consider whether the borrower’s capital structure is sustainable, regardless of whether the transaction is underwritten to hold or to distribute.
- Valuation standards: An institution’s standards should concentrate on the importance of sound methods in the determination and periodic revalidation of enterprise value.
- Pipeline management: An institution should be able to accurately measure exposure on a timely basis; establish policies and procedures that address failed transactions and general market disruptions; and ensure periodic stress tests of exposures to loans not yet distributed to buyers.
- Reporting and analytics: An institution should ensure that management information systems accurately capture key obligor characteristics and aggregates them across business lines and legal entities on a timely basis, with periodic reporting to the institution’s board of directors.
- Risk rating leveraged loans: An institution’s risk rating standards should consider the use of realistic repayment assumptions to determine a borrower’s ability to de-lever to a sustainable level within a reasonable period of time.
- Participants: An institution that participates in leveraged loans should establish underwriting and monitoring standards similar to loans underwritten internally.
- Stress testing: An institution should perform stress testing on leveraged loans held in portfolio as well as those planned for distribution, in accordance with existing inter-agency issuances.