- The Bank of England is sounding the alarm over an underexposed area of the corporate debt market.
- It bears striking similarities to what happened in the US subprime mortgage market in the run up to the financial crisis, the central bank said on Thursday.
- The amount of leveraged loans to nonfinancial companies has risen to about $1.4 trillion globally.
In the bank's record of the October meeting of its Financial Policy Committee — the body tasked with ensuring financial stability in the UK — the BoE mentioned leveraged lending almost 20 times, variously calling it "concerning" and likening it to what happened in the USA with sub prime mortgages in the run up to the financial crisis.
At their most basic level, leveraged loans are loans extended to people and companies with either pre-existing high levels of debt, or a poor credit rating. These loans, therefore tend to have higher interest rates meaning that rewards for lenders are higher, while the risk of default is also higher due to the nature of the customers.
Leveraged lending to corporates has ballooned in recent years, with the global market reaching a value of around $1.4 trillion, according to recent estimates. In the UK alone, £68 billion ($90 billion) of these loans have been issued in the last two years, the Bank of England said on Thursday. This represents around 20% of total UK corporate debt, when also including high yield bonds.
That rapid growth, along with falling standards of underwriting for the loans — effectively giving loans to companies with even more debt, or an even lower credit ratings — means that there are now clear parallels between what is happening in the space, and what happened with US housing in 2006 and 2007, the bank said.
"The global leveraged loan market was larger than – and was growing as quickly as – the US subprime mortgage market had been in 2006," the FPC report noted.
"As with subprime mortgages, underwriting standards had weakened, there was significant uncertainty around the ultimate investors in collateralized loan obligation securitizations and hence their capacity to absorb losses, and borrowers would face higher financing costs if interest rates or credit spreads increased," it added.
The Bank of England's warning comes less than two months after ratings agency Moody's issued a virtually identical warning, saying that the market bears "eerie similarities" to what happened with sub prime mortgages in the run up to the crisis.
"The most serious developing threat to the current cycle is lending to highly leveraged nonfinancial businesses," Mark Zandi, the chief economist at the analytics arm of Moody's said in August.
While it sounded the alarm on the corporate leveraged debt market, the Bank of England struck a reasonably sanguine note, pointing to "important differences" between leveraged loans and what happened in the subprime mortgage market.
"A substantial proportion of subprime mortgages had been financed by relying on short-term wholesale funding, including from money market funds, and there had been an active repo market in subprime mortgage securitizations. Banks had substantial contingent liabilities related to subprime mortgages," it said.
"This was not the case for leveraged loans."