The Federal Reserve warned that froth in the riskiest parts of debt markets may lead to more defaults.
“Signs of excesses that could lead to higher future defaults and losses have emerged in some sectors, including for speculative-grade corporate bonds and leveraged loans,” according to a report published today by the central bank as part of Chair Janet Yellen’s semi-annual testimony to the Senate Banking Committee.
A boom in the market for junk-rated loans has drawn the attention of the Fed and the Office of the Comptroller of the Currency, who have been urging banks since last year to curb risky lending. While issuance has been robust, “underwriting standards have loosened,” according to today’s report.
The central bank said it’s working with other federal regulators to “enhance compliance with previous guidance on issuance, pricing and underwriting standards.”
There have been $222.7 billion of new loans arranged in the U.S. this year after a record $357.9 billion in 2013, according to data compiled by Bloomberg. Loans helped finance some of the biggest leveraged buyouts during the last credit boom.
The Fed, the Federal Deposit Insurance Corp. and the OCC released leveraged-lending guidelines in March 2013 that describes expectations for sound risk management of leveraged-lending activities. The Fed and the OCC followed up with letters starting in September that said banks should establish clear policies that deter the origination of loans classified as having a deficiency that might lead to a loss.
Issuance of leveraged loans continued to be “rapid” during the first half of 2014 and sales of collateralized loan obligations, which buy the debt, also reached “very high levels” from February to April, according to the report.
CLOs pool high-yield corporate loans and slice them into securities of varying risk and return, typically from AAA ratings down to B. Leveraged loans are rated below BBB- by Standard & Poor’s and less than Baa3 at Moody’s Investors Service. (MCO:US)
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