(Bloomberg) -- For the better part of a decade, Janet Yellen has been issuing a warning: Wall Street is piling a dangerous amount of debt onto the balance sheets of risky U.S. businesses.
Time and time again, she has hammered home the point, turning it into a staple of the speeches and interviews she’s given since leaving the top job at the Federal Reserve in 2018. “Regulators should sound the alarm,” she said in one.
But now, as Yellen prepares to take over as Treasury secretary, she may find it difficult to do anything quickly to rein in these markets, experts say. They cite a slew of factors: Interest rates are expected to remain at rock-bottom levels for years; banking watchdogs have little sway over investment banks and private-equity firms that are orchestrating much of the debt binge; and, most importantly, regulatory holdovers installed by President Donald Trump could block new rules.
“Comprehensive action on leveraged lending probably has to wait until the new administration is able to place appointees at all of the banking agencies,” said Gregg Gelzinis, a policy analyst at the Center for American Progress, a progressive think tank. “That’ll take some time.”
In the meantime, the $2.8 trillion market for leveraged loans and junk bonds is booming, as companies with questionable earnings potential take advantage of loose money and lax oversight to add to their sky-high debt burdens. Added to the mix is Covid-19, which threatens to bring a top Yellen concern to fruition: A prolonged economic slump that forces lots of overly levered companies to cut spending and slash jobs.
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Yellen didn’t respond to a request for comment submitted to President-elect Joe Biden’s transition team.
Risky Lending
There are clear signs that Wall Street has ratcheted up the risk. Regulators once rejected deals that saddled borrowers with debt loads that were more than six times their expected Ebitda -- earnings before interest, taxes, depreciation and amortization. Now, roughly 40% of leveraged loans tied to corporate mergers and buyouts boost debt above that threshold, according to data from Covenant Review. Investor protections are also eroding, and lenders have long-since dropped so-called maintenance covenants that allow them to intervene when companies don’t meet performance metrics.
Private equity is often behind these loans. Recent examples include Blackstone Group (NYSE:BX) Inc.’s $4.7 billion purchase of a majority stake in Ancestry.com Inc., the business known for selling family-history research and DNA testing. Credit Suisse (SIX:CSGN) Group AG, Bank of America Corp (NYSE:BAC)., Barclays (LON:BARC) Plc and JPMorgan Chase & Co. (NYSE:JPM) were among banks involved in the deal, which pushed Ancestry.com’s debt well above the level that watchdogs once frowned upon.
Another is KKR & Co (NYSE:KKR).’s more than $3 billion buyout of contact lens retailer 1-800 Contacts where Morgan Stanley (NYSE:MS) led a group of banks in piling on leverage that exceeded seven-times earnings.
Spokesmen for Blackstone, KKR and the banks all declined to comment.
FSOC Warning
During the Trump administration, Fed officials have acknowledged that leveraged lending could lead to a wave of corporate defaults. But they’ve argued it wouldn’t threaten financial stability because risks to banks are limited. That’s because loans are packaged into securities and sold off to investors.
Last week, the Financial Stability Oversight Council -- a panel of regulators led by Treasury secretary Steven Mnuchin -- did raise a fresh concern. In its annual report, the group warned that courts could get overwhelmed with coronavirus-fueled bankruptcy filings. A log-jam might prevent leveraged borrowers from quickly restructuring their debts, forcing many into liquidation, according to FSOC, which Yellen would take over if she’s confirmed by the Senate.
Yellen was a Fed governor in 2013 when the central bank, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency sought to crack down on leveraged lending by issuing guidance that made clear to banks that there was a limit to how much debt regulators would tolerate.
But after Trump took office, Republican Senator Pat Toomey of Pennsylvania challenged the guidance, arguing that lenders couldn’t be forced to abide by something that wasn’t a formal rule. Toomey sought a judgment from the Government Accountability Office, which in 2017 agreed with his stance. Shortly thereafter, the regulators announced they wouldn’t punish banks for violating the six-times Ebitda restriction.
Trump Holdovers
Biden’s regulators could toughen oversight by making the original guidance an official regulation. Still, they’d likely have to wait out some high-level Trump appointees, including Fed Vice Chairman for Supervision Randal Quarles -- who doesn’t have to step down until late 2021 -- and FDIC Chairman Jelena McWilliams -- who has a term that runs into 2023.
It typically takes more than a year to propose restrictions, go through a public comment period and finalize a rule. So if Biden appointees chose to impose new constraints after all of Trump’s regulators have exited, it could take them into 2024 to get it done.
Another issue is that banks policed by the Fed, FDIC and OCC already represent the more cautious side of the market. The agencies have no authority over investment banks and private-equity firms that are putting together the most highly leveraged deals. That’s one reason Yellen has repeatedly called on Congress to pass a new Dodd-Frank Act that gives watchdogs more power over so-called shadow lenders that operate outside the regulated banking sector. The odds of that happening seem slim if Republicans maintain control of the Senate.
Biden’s Watchdogs
Biden’s watchdogs won’t be entirely handcuffed, as supervision can be just as impactful as rules in guiding bankers’ conduct. So firms might fall in line if regulators embedded within lenders make clear they’re bothered by certain practices.
As head of FSOC, Yellen will have strong influence over any policy decisions. For instance, she could ask the council to label leveraged lending a systemically risky behavior, giving the Fed additional authority over the market.
“There are plenty of levers,” said Marcus Stanley, policy director at Americans for Financial Reform, a Washington trade group that advocates for tough Wall Street rules. Biden’s regulators will have ample authority to curtail risks in leveraged lending, because “it’s loan underwriting,” he argued.
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