Syndicated loans, in which multiple lenders put up the money for a single large loan, are a major funding source for large U.S. firms, and since the financial crisis, their use has soared. Accompanying this rise in syndicated loans has been a large increase in loans that lack traditional financial covenants designed to prevent default. A financial covenant clause in a syndicated loan contract typically requires the borrower to pass regular financial fitness tests. Because the financial industry considers loan covenants a major device by which lenders can monitor loan repayment performance, many see this rise in covenant-lite lending as evidence of a decline in credit standards.
Since lower lending standards in the home mortgage market set off the events that led to the financial crisis, this development in the syndicated loan market has drawn much concern from regulators and other market participants.1 One analysis suggests that covenant-lite loans now account for the majority of leveraged—or higher-risk2—syndicated loans and argues that the lack of financial covenants means investors will recover less of their money in the event of default.3 Concern has also been expressed that covenant-lite leveraged loans have become the norm in the leveraged loan market and that traditional covenant protection is even viewed as a stigma, a sign that the borrower is very risky.4 Regulators’ concerns about declining credit standards in the leveraged loan market prompted them to note that covenant-lite loans “may have a place in the overall leveraged lending product set; however, the agencies recognize the additional risk in these structures”5 and to subsequently suggest that “loans with relatively few or weak loan covenants should have other mitigating factors to ensure appropriate credit quality.”6
This article appeared in the Third Quarter 2018 edition of Economic Insights. Download and read the full issue.
[1]See the paper by Guido Lorenzoni for evidence that banks may have incentives to make too many loans. The paper by Robin Greenwood and Samuel Hanson provides evidence that rapid growth in credit to risky borrowers is a sign of an overheating market.
[2]A leveraged loan is a syndicated loan made to a riskier borrower, much as the junk bond market is the portion of the corporate bond market for riskier bond issuers. Although definitions vary on what constitutes “risky,“ Loan Pricing Corporation defines a leveraged loan as one that is either unrated or rated BB+ or lower with an interest rate spread exceeding 150 basis points.
[3]See the research note from Moody’s Investors Service.
[4]See the 2017 Bloomberg article.
[5]See the 2013 interagency guidance. On October 19, 2017, the Government Accountability Office ruled that the leveraged lending guidance should be subject to the requirements of the Congressional Review Act and thus required the guidance to be approved by both houses of Congress. The decision means regulators must now decide whether to reissue the guidance through the rule-setting procedures of Congress, revise it, or let it drop entirely.
[6]See the interagency FAQs from 2014.
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