Leveraged Loan Rise Being Compared to Subprime Mortgage Loan Crisis
Inside Subprime: Aug 29, 2018
By Ben Moore
The current rise in leveraged corporate loans is now being seen as a major area of concern within the current state of the United States’ excessive level of debt. The increase in leveraged loans is now being
compared to the subprime lending boom that led to the financial crisis in 2008. Mark Zandi, the chief economist for Moody’s Analytics, believes that while it is “too early to conclude that nonfinancial businesses will end the current cycle in the way subprime mortgage borrowers did” in 2008, he called the similarities between the two “eerie” even while acknowledging there are still significant differences between current leveraged lending and the subprime mortgage lending crash.
Leading up to the 2008 subprime mortgage lending crash, banks eased their standards and began to provide subprime home mortgages to borrowers with low or poor credit scores. The banks packaged the loans into “mortgage-backed securities” and were given high credit scores which in term made them benefit from “insatiable demand by global investors for residential mortgage securities [that] drove the demand for subprime mortgages, inducing lenders to steadily lower their underwriting standards.” Once the Federal Reserve began to increase rates, the rates for the subprime loans, which are not fixed, rose as well. Consequently, borrowers were left with rising mortgage payments they could no longer afford, which resulted in a high quantity of loan defaults. Now banks are providing similarly structured loans called leveraged loans.These loans are provided to corporations which are already high in debt and also have poor credit ratings, with the loans being tied to company assets as security in the situation of default.
With interest rates back on the rise, similarities are being drawn back to what occurred with subprime loans in 2008. While the current leveraged loan market is worth around $1.4 trillion, corporations with exorbitant debt owe more than $2.5 trillion, coming close to the $3 trillion in debt that accumulated before the subprime mortgage market peaked. And just like the subprime mortgage market, these leveraged loans have all been packaged together as “collateralized loan obligations” mean to offer “rich returns to yield-hungry investors.” Guy LeBas, a bond fund manager at Janney Montgomery Scott, saw the similarities and compared the growth of packaged leveraged loans to the same growth seen with packaged subprime mortgage loans. Guggenheim Partners, an asset management company, recently told their clients in their April report warning that “unlike the last recession, which featured unsustainable levels of household debt, [they] believe the next downturn will be traced back to the corporate debt market.”
However, fiscal stimuli have helped to boost earnings for corporations with high debt, which in turn has offset the increased in leveraged loan debt amounts. Moody’s Analytics has estimated that default rates on leveraged loans are expected to remain low, at around 2.2%, though this percentage will rise as the Federal Reserve raises interest rates and the current economic growth begins to slow. Once that happens, it is expected that the loan defaults will affect a large amount of investors, greater than during the subprime mortgage loan crisis, due to how much larger the leveraged loan market has become.