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Since the Federal Reserve started warning about the risks of “leveraged loans” in 2014, the amount of US leveraged loans outstanding has surged with delicious irony from $700 billion to $1.3 trillion. These things are hot. And now the Fed is even more worried.

The latest warning came from Todd Vermilyea, who leads the Risk, Surveillance, and Data sections at the Fed Board of Governors’ Division of Banking Supervision and Regulation. His responsibilities include, as he says, the Shared National Credit program, “a key interagency program that reviews and assesses risk in the largest and most complex credits shared by multiple financial institutions.”

Leveraged loans are issued by highly leveraged companies with below-investment grade credit ratings (“junk”) to fund primarily:

  • Leveraged buyouts (LBOs) where a private-equity firm buys a company that then has to borrow the money to fund its own acquisition.
  • Special dividends by the acquired company back to its PE firm owners. The euphemism for this form of asset stripping is “recapitalization.”
  • Refinancing existing debt to give the company a leg up with creditors.

Regulators consider leveraged loans too risky for banks to keep on their balance sheet, so banks rearrange them, structure them, collect hefty fees, and sell them to loan mutual funds, pension funds, and other institutional investors, domestic or foreign.

Investors have the hots for leveraged loans because they pay a higher yield, and because the yield is based on a floating rate that rises as interest rates rise. But this is also one of the reasons these loans are even riskier in a rising-interest-rate environment.

In his remarks at the Loan Syndications and Trading Association Conference in New York, Vermilyea warned that “there may be material loosening of terms and weaknesses in risk management of the leveraged loan market,” and that “some institutions could be taking on risk without the appropriate mitigating controls.”

Read More: The Fed Broadsides $1.3-Trillion “Leveraged Loan” Market

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