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The debt market is littered with risky loans

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There are worrisome trends developing in the lending market, reporting from the Washington Post and Bloomberg shows.

"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."
Damian Paletta of the Post writes.

Why it matters: Big banks and other financial institutions have originated the risky loans to "hundreds of cash-strapped companies, many of which could be unable to repay if the economy slows or interest rates rise."

  • One of the big worries about the so-called leveraged loans is that they are often provided to borrowers "who have access to less cash than others, and who tend to fall behind on payments with greater frequency when interest rates go up or the economy slows down."
  • “Over the past 35 years, these are some of the worst underwritten loans in the bank,” Timothy Long, a former chief national bank examiner at the Office of the Comptroller of the Currency, told the Post.

Further, there's also been a growth of so-called covenant-lite loans, which lack traditional loan requirements and offer less protection for lenders and investors than traditionally structured credits if borrowers default.

Between the lines: Financial institutions are lending to less-qualified borrowers as a result of "grade inflation," Adam Tempkin at Bloomberg reports.

  • "Consumer credit scores have been artificially inflated over the past decade and are masking the real danger the riskiest borrowers pose to hundreds of billions of dollars of debt," Tempkin writes, citing analysts and economists at Goldman Sachs and Moody’s Analytics, and research from the Federal Reserve.
  • “Borrowers with low credit scores in 2019 pose a much higher relative risk,” Cris deRitis, deputy chief economist at Moody’s Analytics, told Tempkin.

My thought bubble: There are a lot of bad bets in the global debt market. As the economy slows, borrowers may have trouble making payments, which could lead to a wave of defaults. Fortunately, much of the risk is not held by banks as it was during the financial crisis, so there's unlikely to be a repeat of the systemic failure we saw in 2007.

  • That doesn't mean the next recession won't happen, just that it won't look like the last one.