For readers who remember the sub-prime disaster and the “collateralised debt obligations” (CDOs) which were part of it, here’s a recent report to give one pause.
The Bank of England’s Financial Policy Committee (FPC) has recently pointed to rapid growth of “leveraged loans” in the UK as potential problem. In its minutes of its October meeting, it noted the growth of leveraged loans, firstly in the US but also in the UK, and said the increased use of leveraged loans and their facilitation by non-bank lenders “could pose risks to financial stability.”
Leveraged loans are loans to non-investment grade or already highly-levered firms. In itself, lending to higher-risk business is not necessarily a problem for a country’s financial stability. However, the FPC warned of the parallels between the growth of leveraged loans and the US subprime mortgage market in 2006. “As with subprime mortgages, underwriting standards had weakened, there was significant uncertainty around the ultimate investors in collateralised loan obligation securitisations and hence their capacity to absorb losses, and borrowers would face higher financing costs if interest rates or credit spreads increased.”
Having said that, “the Committee recognised that there were important differences between these two markets.” Leveraged loans were not necessarily funded by short-term wholesale funding and banks did not have substantial contingent liabilities relating to the loans.
A little ominously, the FPC said another advantage leveraged loans had over CDOs and their derivatives is the presence of diversification. “Moreover, unlike for subprime mortgages, there were limited synthetic securitisations of leveraged loans, and collateralised loan obligations were diversified by industry and, for European vehicles, by country.” Diversification was the selling point behind many a failed CDO in 2007, 2008 and 2009.