Are leveraged loans ticking time bombs?


The longer the monetary tightening goes on, the more likely it is to trigger real trouble in the region where credit growth has exploded in America since the 2008 global financial crisis.

It is in the private lending market, outside of the heavily regulated post-2008 commercial banking system, and particularly in leveraged institutional lending to finance private equity transactions.

On this point, a chart from a 2019 IMF report clearly showed that non-bank private lending in America grew at a faster rate than banks’ commercial and industrial lending (see next chart and IMF report : “Global Financial Stability Report: Lower for longer», October 2019).

For example, leveraged loans and private market loans accounted for 43% of total business loans outstanding in 2018, up from around a third in 2010.

Outstanding loans in the United States (in billions of dollars)

Source: IMF: Global Financial Stability Report: Lower for longer, October 2019

The situation has since become more extreme.

Total outstanding leveraged loans in the United States stood at US$1.39 billion at the end of 1Q22, according to data from the latest Federal Reserve report Financial Stability Report published in May and provider of information on leveraged loans Commentary and data used (LCD). This represents an increase of $893 billion or 180% from $497 billion at the end of 2010.

In contrast, commercial and industrial loans from US banks increased by US$1.34 billion or 112%, from US$1.19 billion at the end of 2010 to US$2.53 billion at the end of 2010. from 1Q22.

Outstanding US leveraged loans and commercial and industrial (C&I) loans from banks

Source: Federal Reserve – Financial Stability Report, May 2022; S&P Global, Commentary and Leveraged Data (LCD)

While a recent McKinsey research report released in March shows that global private equity fundraising grew 22% year-on-year to $680 billion in 2021, fundraising in North America North increased by 25% to $400 billion (see McKinsey report: “Global Private Markets Review 2022 – Private Markets Reach New Heights», March 2022).

Global private equity fundraising

Source: McKinsey Global Private Markets Review 2022, Preqin

The only critical point that can delay a rout in this area, and this is an important point, is that investors in private equity funds are usually locked in for years, not months.

Their investments are also not marked to market daily, preventing self-fueled panic selling of the kind seen in recent months in crypto and the non-profit tech theme.

In this regard, ignorance seems like bliss, as highlighted in the attached article discussing the curious mindset that has driven huge asset allocation flows in the alternative investment space (see l AQR Capital Management article by co-founder Cliff Asness: “Illiquidity discount?», December 19, 2019).

A marketing of private loans could trigger a cascade

Yet the longer the cycle of monetary tightening continues, the more refinancings will expose the unrealistic “brands” valuing these investments and the associated fees levied on them, and the more likely there will be a regulatory post-mortem after the event on why public pension funds and others have already agreed to such restrictive terms, in terms of both the length of lockdowns and the lack of transparent market-based pricing.

But while this is a potential problem looming, the key issue right now, aside from the inflation data itself, is the Fed’s stance and the shifting policy pressures it’s under.

In this regard, this author has long criticized the Fed for its role in promoting the socialization of credit risk and, in the era of post-2008 quanto easing, promoting inequality as perception grew, wrongly or rightly, that there was one rule for Wall Street and another for Main Street.

While this issue came to the fore in 2008 with long-term political consequences, as is all too evident in the extreme polarization of American politics today, the origins of this problem actually go back the bailout of Long-Term Capital Management in 1998, if not before.

The Fed is focusing on Main Street, not Wall Street

Yet if that’s in the past, the problem now is that the Fed has rightly begun to refocus on Main Street.

And in this regard, it is true that inflation is a regressive tax that penalizes the poorest households the most.

It is also true that consumers do not distinguish between consumer inflation and underlying inflation.

Likewise, the political process of energy transition is inflationary and is therefore also a regressive tax in practice, while the conduct of war is simply inflationary.

An acknowledgment of this aspect of inflation was made in an important speech by Fed Governor Lael Brainard, who since May 23 has become the Vice Chairman of the Fed (see Brainard’s speech at a virtual conference to the Minneapolis Fed:Variation in household inflation experiences», April 5, 2022).

What’s interesting about Brainard’s speech in April is her emphasis on the socially regressive impact of inflation.

Thus, she said the burden is particularly heavy for households with more limited resources, noting that low-income households spend 77% of their income on necessities compared to 31% for higher-income households.

She also explained how several studies have demonstrated that the consumption baskets of low-income households have experienced higher than average inflation rates over time, while adding that it would be useful to have data on the consumer inflation broken down by different demographic groups, as is the case with labor market and personal income data in the United States.

But for the moment these data do not exist.

If people like Brainard continue to insist on such factors, it may take them longer to become accommodating than this writer previously assumed.

Yet this will only become clear if and when there is hard evidence of a weakening labor market, which is not yet really the case.

But this point is surely to come.

Is 18% Fed Funds possible?

Meanwhile, it’s also interesting that Brainard quoted at the beginning of his speech a comment made by former Fed Chairman Paul Volcker almost 43 years ago, who, in noting that the dual mandate of the The Fed is not a proposition of either, said runaway inflation “would be the greatest threat to the continued growth of the economy…and, ultimately, to the use “.

Speaking of the great man who died in December 2019, it is useful to compare where we are now, in terms of the potential for rate hikes in the future, and what happened in the 1970s.

The first point to note is that long before Volcker became Fed Chairman in August 1979, the federal funds rate had risen from 5.5% in early 1973 to 11% at a time when US inflation CPI reached 7.4% in August 1973.

This was under the much-maligned Fed Chairman Arthur Burns. So, by recent G7 central banking standards, Burns was an extreme hawk!

Also by the time Volcker took over in August 1979, the CPI was at 11.8%.

He then raised the federal funds rate by about ten percentage points over six months in 1979 and 1980 and imposed real rates of 9% on the US economy.

US Federal Funds Rate and CPI Inflation (1970-82)

Note: Based on the average monthly effective federal funds rate. Source: Federal Reserve, Bureau of Labor Statistics

Real effective US federal funds rate deflated by the CPI

Source: Federal Reserve, Bureau of Labor Statistics

In this regard, you don’t have to be an economist to understand that monetary policy is only truly restrictive if short-term interest rates are above the level of inflation.

A repeat of the real fed funds rate seen under Burns as president would lead to a nominal fed funds rate of 13% today relative to the current CPI level, and a repeat of what went under Volcker would mean a federal funds rate of 18%.

In such circumstances, we will no longer talk about asset price inflation, but rather the opposite, and the point of discussion, as in any real bear market, will be who has lost the least.

This author does not predict such an interest rate outcome at this point, but only outlines what the consequences will be if the Fed really chooses to fight inflation properly.

Meanwhile, the other temptation for central banks and governments, faced with the market outcome of rising inflation in the form of rising government bond yields, will be to re-engage financial repression by imposing yield curve control by pricing longer-term bonds. term bonds.

This is clearly not the current direction of travel in America and Europe.

But that could change as the financial consequences of rising government bond yields became increasingly evident in terms of rising public debt servicing costs in the context of the massive increase in debt. public since 2008, a process further accelerated by the political response to the pandemic.

Total US public debt, for example, fell from US$9.5 billion or 65% of GDP at the end of 2Q08 to US$30.4 billion or 129% of annualized GDP at the end of 2Q08. 1T22.

US public debt as % of annualized GDP

Source: Federal Reserve Bank of St. Louis

The opinions expressed in Chris Wood’s column on Grizzle reflect the personal opinion of Chris Wood only, and have not been reviewed or endorsed by Jefferies. The information in the column has not been reviewed or verified by Jefferies. None of Jefferies, its affiliates or its employees, directors or officers shall be liable in any way in connection with the content posted on this website.

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