Leveraged lending is not posing a major risk to U.S. financial stability but financial regulators are still cautious, according to a GAO report released Wednesday.
Noting comparisons by regulators and other to the pre-2008 subprime mortgage market, the GAO report looked at whether loan origination and securitization could spread similar risk, particularly during the COVID-19 pandemic.
Before the pandemic, the Financial Stability Oversight Council and other regulators found that riskier borrower profiles and looser underwriting standards left leveraged lending market participants vulnerable to losses in the event of a downturn. After March 2020, loans suffered record downgrades and increased defaults, but the highest-rated CLO securities remained resilient and, as of September, leveraged lending was not found to present significant threats to financial stability, the report said.
In contrast to the previous financial crisis, CLO securities appear to pose less of a risk with better investor protections, more insulation from market swings, and fewer ties to other risky, complex instruments, the report said.
"Based on regulators' assessments, leveraged lending activities had not contributed significantly to the distress of any large financial entity whose failure could threaten financial stability. Large banks' strong capital positions have allowed them to manage their leveraged lending exposures, and the exposure of insurers and other investors also appeared manageable," the report said, and mutual funds experiencing redemptions by investors were able to meet them, in part, by selling leveraged loan holdings.
The report recommended the FSOC "better prepare against threats to stability" by having its chairman, the secretary of the Treasury, conduct crisis scenario exercises. Also, Congress should consider legislative changes to enhance FSOC authority, actions that FSOC officials said they would take if necessary.
According to the report, the market for institutional leveraged loans — corporate loans made to businesses with high levels of debt — grew to $1.2 trillion in 2019 from an estimated $500 billion in 2010, fueled largely by investor demand for CLO securities offering a higher rate of return.
Drew Maloney, president and CEO of private equity advocacy group American Investment Council, said the GAO report highlights the role of the private credit market. "Throughout the COVID-19 crisis, we have seen how companies of all sizes across the country have relied on private credit to keep their doors open and their workers employed," Mr. Maloney said in an emailed statement.
