Leveraged loans: the big risk for the US economy

What made the GFC (Global Financial Crisis, 2007-2008) much worse was unrestrained and ill-advised lending by the banks in the years before the crisis.  Banks lent profusely to home buyers, with low buyer deposits and "liar loans", and packaged these loans into bundles (Collateralised Debt Obligations, or CDOs) which remarkably inept rating agencies rated AAA.  When the downturn came, the defaults on the mortgages and the CDOs took down the banking system and with it the world's economies.  In the years after the GFC, banking regulators increased required capital standards and tightened regulations.

Now something very similar is happening again, and the tightened standards and regulations imposed after the crisis have been loosened by the US government.  It seems no lesson is too serious to be unlearned by the Right.

[From The Washington Post]

Actions by federal regulators and Republicans in Congress over the past two years have paved the way for banks and other financial companies to issue more than $1 trillion in risky corporate loans, sparking fears that Washington and Wall Street are repeating the mistakes made before the financial crisis.

The moves undercut policies put in place by banking regulators six years ago that aimed to prevent high-risk lending from once again damaging the economy.

Now, regulators and even White House officials are struggling to comprehend the scope and potential dangers of the massive pool of credits, known as leveraged loans, they helped create.

Goldman Sachs, Wells Fargo, JP Morgan Chase, Bank of America and other financial companies have originated these loans to hundreds of cash-strapped companies, many of which could be unable to repay if the economy slows or interest rates rise.

“This means that the next downturn that we have could be more serious and longer-lasting and more difficult to deal with than it would have been if we had constrained these practices,” former Federal Reserve chair Janet L. Yellen said in an interview.

The lending boom was precipitated, in part, by the rush to water down regulations at the start of the Trump administration. That’s when newly minted regulators — many with close ties to the financial industry — sought to strip away post-crisis financial rules and find ways to juice the economy by encouraging more lending.

One of their top targets was leveraged loans. These are giant loans that banks make to heavily indebted — in financial speak, highly leveraged — companies. Bankers often have little assurance that the loans can be repaid, which can make them particularly risky. Bankers earn large fees off these products, and many banking executives say their institutions are sheltered from losses because they sell the loans to other investors such as hedge funds, mutual funds and insurance companies.

As regulators scaled back scrutiny, bankers began to binge.

Financial companies issued a total of $1.271 trillion in leveraged loans in 2017 and 2018, 40 percent more than in 2015 and 2016, according to S&P Global Market Intelligence. More than 80 percent of the loans made in 2018 were made with fewer restrictions on the borrower and fewer protections for the lender in the event the loan falls into default.

[Read more here]

It seems very likely that the US will enter a recession this year—I would say an 80% chance.  At the same time, the yield curve (the spread between short-term rates and long-term rates) has gone negative in the US, reducing bank profits. 

Source: Business Insider

There is also a pending crisis in auto loans.  Just as happened with mortgages before the GFC, when default rates on mortgages reached record highs even before the recession began, so it is with car loans now.   What will happen when unemployment starts to rise?  It's obvious, isn't it. 

As I pointed out here, PMIs for the world are sliding.  The only good news is that Chinese re-stimulation measures are having some effect.  Meanwhile, in Europe and Japan, Central Bank discount rates are already at zero, and the banking systems remain parlous.  How will the authorities counter if growths slows any further and debt defaults explode? 

If the world goes into recession, will we experience a crisis as severe as the GFC, with even fewer tools to avert the disaster?  My concerns are rising.