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Credit Bubble Comeback: Feds Warn Of Dangers In Leveraged Loan Market

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Fed Chairman Ben Bernanke is on lookout for signs of a new credit bubble. The Fed has already found signs of trouble in the leveraged loan market. (AP Photo/Carolyn Kaster)
Fed Chairman Ben Bernanke is on lookout for signs of a new credit bubble. The Fed has already found signs of trouble in the leveraged loan market. (AP Photo/Carolyn Kaster)

Ben Bernanke recently said the Fed is on the lookout for trouble in credit markets. It didn't have to look very long.

The Federal Reserve and other bank regulators on Thursday warned that there are problems brewing in the market for what are known as "leveraged loans," or loans to companies that already have debt problems. At the risk of stretching the comparison too far, they're sort of like subprime corporate debt.

The market ballooned in size ahead of the financial crisis, a symptom of the feverish risk-taking of the time, as banks let their lending standards slip in exchange for extra cash. The market collapsed along with everything else, but has recently made a comeback, with $78 billion in deals in February. The February total tops the previous record set in February 2007, according to the Wall Street Journal.

Also making a comeback: Some of the same shoddy lending practices that got the market in trouble just a few years ago.

"[P]rudent underwriting practices have deteriorated," the Fed, Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency said in a press release. The Wall Street Journal first reported on the agencies' warning.

In recent deals, banks have increasingly stripped away investor protections, or "covenants," that help lenders get their money back in the event the debt goes bad, the agencies said. Some banks are making pretty "aggressive" assumptions about just how much debt they are able to pile on already shaky borrowers, according to the release.

Maybe even more troubling, the agencies said that banks in this market don't always seem to have a clear idea of just how much risk they are taking on when they dole out these loans.

"Management information systems at some institutions have proven less than satisfactory in accurately aggregating exposures on a timely basis," the agencies said.

That's Fed-speak for: These banks don't always know what they're doing.

Earlier this week, in justifying the Fed's extreme measures to help the economy, including rock-bottom interest rates and $85 billion in monthly bond purchases, Bernanke tried to reassure skeptics that the Fed would keep an eye out for signs the credit market was getting out of hand.

Credit markets are clearly not back to the truly insane days of the mid-2000s. But, there are early signs that some of the risky behavior of the time is starting to come back. Synthetic collateralized debt obligations, which helped sink American International Group, have reappeared. Private equity is finding credit as easy as it was during its mid-decade boom.

And the risky "shadow banking" market, where banks go daily for short-term borrowing, has only barely dipped from its credit-bubble peak, FT Alphaville charted on Thursday.

None of these things will cause another financial crisis tomorrow. But it's not too soon to start keeping an eye on them.

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