Dodd-Frank At Work—–High Risk Loans Driven Into The Nonbank Shadows

By Christine Idzelis and Craig Torres, David Stockman’s Contra Corner Regulators’ efforts to rein in Wall Street’s biggest banks are in danger of backfiring. Guidelines aimed at strengthening lending standards are shifting the market for high-yield credit to less-supervised loan funds, raising alarm this week from the Financial Stability Oversight Council. Because the funds don’t have depositors, some of their money comes from Wall Street banks, leaving systemically important institutions exposed to risks regulators hoped to avoid. Loans by nonbanks such as KKR & Co. and Apollo Global Management LLC affiliates are a small part of the market, but they’re growing. Direct-lending funds, which raise money from institutional investors such as pension funds and insurance companies, surged to a global record last year of $29.9 billion, according to financial data firm Preqin. Loans by U.S. business development companies, or BDCs, many of which have credit lines with banks, jumped to $55 billion last year from $17 billion in 2010, according to Deloitte LLP. Asset managers are reshaping the market for lending to midsize companies, some top U.S. bankers told the Federal Reserve Board earlier this month. Regulators have scrutinized large banks for risk, publishing strict guidance on leveraged lending in 2013. That’s allowing non-bank funds, many with ties to private-equity firms, to fill the void by helping finance buyouts and indebted companies. The credit sustains jobs and businesses, but it’s also operating beyond the oversight of bank supervisors. Risk Profile “Right now we are, and will be over the next foreseeable future, the banks for middle-market credit,” Keith Read, a senior managing director at Cerberus Capital Management LP, said on an April 21 panel at IMN’s Investors’ Conference on CLOs & Leveraged Loans in New York. “The capital is flowing into this space and it’s alternative lenders like ourselves and others that are really providing capital, and we’re filling that vacuum as the banks go up-market.” Regulators haven’t acted on the growth in alternative financing because the volumes are small compared to the total assets of the largest banks. But as fund managers extend credit at a faster pace, banking executives on the Fed’s advisory council such as Kelly King, chairman and chief executive officer of BB&T Corp., and Ralph W. Babb Jr., chairman and CEO of Comerica Inc., are pointing out the risks of unsupervised lenders. “A material percentage of loans in the leveraged lending space are being originated by non-bank competitors,” they told Fed officials according to minutes of a May 8 meeting. “Those accepting the highest risk continue to be outside of the traditional bank market.” More Scrutiny Angel Ubide, a senior fellow at the Peterson Institute for International Economics in Washington and a former adviser to hedge funds Tudor Investment Corp. and D.E. Shaw Group, calls BDCs and private credit funds “Dodd-Frank banks” because they’ve grown in the wake of the 2010 Dodd-Frank Act’s heightened supervisory scrutiny of regulated lenders. “I think regulators are looking to change the risk profile of the banking sector,” said Todd Owens, CEO of Fifth Street Finance Corp., a publicly traded BDC with $2.7 billion in assets under management, about 94 percent of which are loans. “It’s a big opportunity for companies like ours.” Firms like Fifth Street, KKR and Apollo are regulated by the U.S. Securities and Exchange Commission. They aren’t constrained by leveraged-lending guidelines that the Fed, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. issued in March 2013 to curb risky underwriting. Erin Stattel, an SEC spokeswoman, declined to comment. Underwriting Standards The guidance, which specifies that a deal pushing a company’s debt level to more than six times a measure of earnings raises concern, has slowed issuance in the larger, broadly syndicated loan market where financing is arranged by banks and distributed to investors. The FSOC, a panel created by the Dodd-Frank Act to coordinate supervision across regulators and headed by Treasury Secretary Jacob J. Lew, said in a report this week that firms “not subject to the guidance” could originate more risky loans. “The migration in credit origination outside of the banking system could result in a further decline in underwriting standards for those particular loans, which could result in larger losses in stressed conditions,” it said. Private Equity The majority of lending done by BDCs is for companies that are owned or being bought by private-equity firms, according to Meghan Neenan, an analyst with Fitch Ratings. Interest rates in the mid-market tend to be higher than in broadly syndicated deals, attracting yield-starved investors as the Fed keeps its benchmark rate near zero. She estimates loans held by the larger BDCs have an average 11 percent yield-to-maturity. Apollo, the buyout firm led by Leon Black, lends to mid-sized businesses with as much as $2 billion of revenue through its publicly traded BDC, Apollo Investment Corp., which had $3.56 billion of total assets at the end of March, according to regulatory filings. KKR, the private-equity firm led by Henry Kravis and George Roberts, co-manages a BDC that isn’t publicly listed, and last month said it closed a $1.34 billion direct lending fund. “You’re seeing a more competitive landscape in the mid-market,” said Jai Khanna, a Chicago-based partner at Winston & Strawn LLP. “Everyone is trying to increase market share.” Credit Lines BDCs raise equity from shareholders and then borrow from banks and bondholders to create a pool of cash they can loan to companies. Borrowing to boost returns is a potential concern should market sentiment suddenly shift in a downturn. Smaller loans are harder to trade and leverage could jump if turmoil in markets for high-yield, high-risk debt results in a steep writedown of their holdings. Their own borrowing costs could then rise, and BDCs may find it difficult to issue bonds or equity to repay their credit lines. “If Wall Street and the big banks stopped lending to those facilities in any way, that would be a big problem in the industry,” Owens said. Firms that benefit from big-bank backing include Ares Capital Corp., a New York-based BDC with $8.9 billion of assets. Ares can borrow as much as $1.29 billion from a credit line provided by a syndicate of nearly two dozen banks led by JPMorgan Chase & Co., SunTrust Banks Inc. and Bank of America Corp., according to a regulatory filing. The company said it has a total of $2.2 billion in committed bank lines, as well as investment-grade bonds that help finance its investments. Fort Worth, Texas-based TPG Specialty Lending Inc. has a $781 million credit line, according to a filing this month. The BDC, which went public last year, has $1.37 billion of assets. Representatives of Apollo, Bank of America, JPMorgan, KKR and TPG declined to comment. Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc., a Washington consulting firm whose clients include the world’s largest banks, said non-bank lenders haven’t been tested by a recession or higher interest rates. Their loan growth is being driven by “an absence of regulation.” “Nonbanks may fund a lot of corporate credit because they can — at least if market volatility allows,” Petrou said in a speech in October. The absence of rules “clears take-off.” “Safe landing?” she said. “That’s another question.”

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