Leveraged Loans could Cause another Global Financial Crisis

“If you want to worry about something in the next two to three years, this is it”. These are the words of an investment chief, Anton Pil of J.P. Morgan who manages $100b worth of investment.

He wasn’t talking about pollution or overpopulation, but instead was discussing leveraged loans. Compared to the bigger picture type issues of pollution and overpopulation, leveraged loans may not rank the highest but it is most definitely a pressing issue, and one that needs to be addressed.

Recently, the Bank of England (BoE) shared their concerns surrounding the growth in leveraged loans. A leveraged loan is a type of loan that is given to risky companies that have either accumulated a large amount of debt previously or have a poor credit history. The loan is also given by private lenders.

However, the BoE aren’t the only bank to have taken notice of leveraged loans, both Australia’s central bank and the Bank of International Settlements have recognised the enormous growth in leveraged loans which stands at over $1 trillion.

One of the main reasons for the huge rise in leveraged loans was due to the increasing number of lenders issuing loans under looser terms. They are known as, ‘covenant-lite’ arrangements. Less than 10 years ago, covenant-lite arrangements represented a fraction of issuance, but currently occupy more than 80% of the market today.

With the rapid rise in leveraged loans being noticed by central banks around the globe; financial seniors are comparing the movement to the toxic debt vehicles that caused the Global Financial Crisis of 2007-08.

Central banks are becoming increasingly worried about the continual weakening of lending standards for leveraged loans as it’s making it easier and easier for riskier companies to access more money. The BoE have begun to take precautions; such as including leveraged loans into their financial stability “stress tests” which model the economy’s capability to withstand any large shocks.

Interestingly, one other contributing factor to the leveraged loan crisis is the growing appetite for risk by businesses. It could be seen as a positive that companies are willing to invest in order to compete in the market, thus boosting economic growth. However, a problem with the unregulated lending of leveraged loans is that it offers little to no protection for the creditor in the event of default.

It’s clear to see why people are starting to take notice of leveraged loans, the path they are taking looks incredibly similar to the one we followed that caused the Global Financial Crisis, and that is most certainly a position that nobody wants to be in.

We’ve been warned by one of the top dogs at J.P. Morgan and the UK’s central bank, so there can be no complaints if the UK’s financial system goes bust. I guess all we can do is wait two or three years to see if Pil was right.

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