Banks healthy enough to absorb leveraged-loan risks: Moody’s

Are concerns about banks’ exposure to leveraged loans overblown?

Though lawmakers and regulators are sounding the alarm and at least one regional bank is scaling back its leveraged lending due to credit quality concerns, a new report from Moody’s Investors Service said that banks’ overall exposure to leveraged loans is modest when compared with other loan categories.

It also said that banks’ “healthy earnings and strong capital buffers” are adequate enough to absorb the risks from both holding leveraged loans and investing in leveraged loans that are then packaged into securities.

In recent months, Sen. Elizabeth Warren, D-Mass., and other elected officials have raised concerns about the rise of leveraged loans on banks’ balance sheets. A Federal Reserve Board regulator also said in October that he was concerned about “a material loosening of terms” in leveraged lending, and a recent interagency report on shared national credits found that leveraged loans made up the majority of problem credits.

Meanwhile, the $28 billion-asset Texas Capital Bancshares in the fourth quarter boosted its loan-loss provision to account for deterioration in its leveraged-loan portfolio. The Dallas company also said it would temporarily stop originating new leveraged loans.

Leveraged loans, including amounts outstanding and undrawn commitments, accounted for $2 trillion, or 47%, of all shared national credits at Sept. 30, up from $1.8 trillion, or 41%, a year earlier.

In its report, Moody’s said that despite overall growth in the sector, leveraged loans represent “a small proportion of [banks’] total commercial and industrial loan exposures.”

It did, however, raise concerns about lending standards. A metric it uses to measure the strength of lenders’ underwriting showed that standards have weakened considerably over the last two years.

If a recession hits, those weaker underwriting standards could cause problems for lenders and borrowers.

“Rising interest rates, tighter market liquidity and economic downturns can raise borrowers’ refinancing risk, reduce leveraged loan valuations and ultimately lead to market and credit losses,” Moody’s said.

Bankers like leveraged loans because they carry higher yields and offer growth potential at a time when demand in other loan categories remains spotty. Consequently, many banks expect to modestly grow their portfolios of leveraged loans.

In a recent survey conducted by Moody’s, about 45% of bank executives said they expect their outstanding leveraged loans to moderately increase over the next three years. Only 11% of executives expect their exposure to moderately decrease.

Several bank executives said during fourth-quarter earnings calls that their leveraged-loan portfolios were healthy.

“For the most part, they perform pretty well,” John Martin, chief credit officer at the $9.9 billion-asset First Merchants Bank in Muncie, Ind., said during a Jan. 31 conference call. Martin was referring both to the bank’s $310 million leveraged-loan portfolio and its $250 million sponsored-finance book.

“I have been reading a lot of the media and some of the larger banks and the issues that they’ve been having,” Martin said. “We really haven’t seen that through the portfolio thus far.”