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Current State of the Leveraged Loan Market

Current State of the Leveraged Loan Market

On , the Securities and Exchange Commission's Investor Advisory Committee held a hearing to discuss the risks of increased leverage in the loan market and the potential impact leveraged loans and collateralized loan obligations (CLOs) could have on the broader economy. The Committee sought to identify systematic risks to the market, noting areas of concern and recognizing regulatory implications. The risks identified by panelists included covenant-lite loans, regulatory capital arbitrage, and inconsistent definitions of EBITDA.

The leveraged loan and CLO markets are performing well, and there appears to be more discipline on overall leverage levels than there was in the years leading up to the 2007 financial crisis. Concern, however, remains among financial regulators. These concerns can be distilled into three elements:

  • Covenant-lite loans have eliminated the early warning system that would alert a lender to a borrower's declining economic health and removed the ability for a lender to reassess the loan or potentially intervene before a borrower defaulted.
  • Regulatory capital arbitrage has allowed institutions to manipulate levels of risk and capital, and increased competition among rating agencies has led to rating shopping and raised questions regarding the accuracy of leveraged loan ratings.