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Of the 954 leveraged loans sold to investors in 2021 through November, 33 percent of the loans were made to companies whose debts exceeded earnings by at least six times, the Financial Times reported.
The loans exceed a 2013 guideline adopted by the U.S. Comptroller of the Currency, the Federal Reserve, and the Federal Deposit Insurance Corporation that leveraged loans to a company not exceeding the six-times limit.
“Generally,” the guideline states, a company’s debt that surpasses six times its earnings before interest, taxes, depreciation, and amortization (EBITA) “raises concerns for most industries.”
“There is an insane amount of leverage in the system,” Dennis Kelleher, president of the nonprofit Better Markets financial advocacy group, told the Financial Times.
“It has created a ticking time bomb,” he warned, and which we noted in “Will Junk Bonds Turn to Junk?” (14 Dec 2021).
As interest rates rise, companies top-heavy with debt could fail, sending shock waves through the financial system.
Also, accounting customs allow borrowers to include “add-backs” in earnings calculations, showing higher earnings on paper and thus justifying even more debt.
The debt problem has been worsened by the Fed’s cheap money and $120-billion monthly bond purchases that began in March 2020, Kelleher said.
The Fed’s actions, designed to see the economy through the COVID crisis, lowered lending standards, he pointed out.
The computer and electronics industry holds 20 percent of the loans exceeding the six-times guideline, up from 13 percent from 2013 when the guidance was written.
The leasing and service sectors also have a high proportion of over-leveraged debt, the FT noted.
TREND FORECAST: Loose lending policies began before the COVID virus arrived but are unlikely to survive the Fed’s end to bond-buying and higher interest rates. As markets collide with the reality of a faltering economy, unbuffered by permissive Fed policies, lenders will protect themselves with stricter lending standards.
As a result, more businesses will be forced to restructure debt on less favorable terms than they have become used to; other companies will be unable to survive tighter standards and the number of corporate defaults will rise.