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Fed urged to get more serious about US corporate debt risks

New York

BANKERS, executives and investors are warning Federal Reserve officials that record leveraged lending to companies from lightly-regulated corners of Wall Street could make any economic downturn harder to manage.

With the second-longest US expansion in its advanced stages, the worry is that a key part of the credit market could be particularly vulnerable to a slowdown, as highly-indebted companies face a greater risk of default.

In a worst-case scenario, the defaults could worsen any downturn by destabilising big non-bank lenders and hitting employment across US industries. Leveraged loans are typically made to already indebted firms with low credit ratings, and the concern is that the loans would be difficult to collect or resell in a downturn.

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"Just the sheer size of market-based credit intermediation is very different (from years past) and we don't quite know how that is going to behave in a downturn," said Tobias Adrian, director of monetary and capital markets at International Monetary Fund.

Few believe leveraged loans today would set off a crisis similar to the one triggered by a wave of defaults in the US sub-prime mortgage market in 2008, since they are focused on a smaller part of the economy than the sprawling housing market. But they risk handcuffing companies and lenders trying to react to a downturn, possibly making it more painful.

The central bank itself may have contributed to the ballooning US$1.12 trillion US leveraged loan market by holding interest rates near zero for seven years in the wake of the recession to encourage lending and investment.

By comparison, collateralised debt obligations, which spread toxic housing debt through the world's financial system, was worth some US$61 trillion globally in 2007, according to the Bank for International Settlements.

The total leveraged loan market is now about double what it was in 2008, and it has grown 17 per cent so far this year, based on the S&P/LSTA Leveraged Loan Index.

A record 59 per cent of those "junk" loans are rated B+ or worse, according to S&P Global. "Risks attributable from this debt binge are significant," it said last month.

Private discussions increasingly centre on the growth of leveraged credit and the risk it poses to overall financial stability. The council is made of bankers appointed from the Fed's 12 regional districts to consult with the central bank.

For example, some regional Fed presidents have asked corporate chief executives whether they are seeing leveraged loans use debt structures that would appear particularly dangerous in a credit crunch.

In Washington, one banker on the advisory council told Fed governors that non-regulated lenders were "driving aggressive structures" and cutting out heavily-regulated banks, according to the minutes of a September advisory council meeting.

Scott Minerd, managing partner at Guggenheim Partners, said president John Williams and some of his colleagues at the New York Fed were "taken aback" when he told an advisory meeting that he did not think the Fed could safely avoid a messy recession in the face of the credit build-up and other risks.

"Because it is now so extreme, any attempt to rein in credit expansion is going to ultimately blow up," Mr Minerd said at the Reuters Global Investment 2019 Outlook Summit this month.

Credit spreads - or the difference between government and corporate borrowing costs - have already widened to a two-year high for both investment-grade and high-yield debt. In what could be a taste of things to come, General Electric's bonds tumbled this month as it scrambled to raise cash.

Mr Minerd said the Fed and other regulators had not considered a scenario in which credit spreads would rise much further, prompting regulators to force liquidations at insurers and other firms that had bought so-called collateralised loan obligations. "They don't really have a good handle on where this risk lives."

The central bank has been paying more attention to elevated leveraged loans this year, with Fed Chair Jerome Powell telling a public forum earlier this month: "There is some significant corporate borrowing and we have our eyes on that." But he stressed that risks were "pretty moderate" when viewed through a broader lens that includes asset prices, bank leverage and household and business borrowing. REUTERS