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Dallas Fed Says Leveraged Loan Bubble Is Getting Dangerous

Sept. 22, 2014 (EIRNS)—With the European banking system loaded with EU2 trillion of bad debts and near collapse, the Federal Reserve Bank of Dallas on Sept. 17 issued a report which warned that in the United States banking system as well, the so-called "leveraged loan" bubble could get out of control.

Leveraged loans are loosely defined, but are essentially bank or private fund loans to corporations which are already overindebted, by basic underwriting standards, before the new loans, and are at high risk of becoming distressed debt, although not in default. They could be thought of as the corporate analog of the infamous subprime mortgages.

The bank’s report says that this bubble is already considerably larger than before the 2007-08 crash, with $650 billion in new high-risk leverage loans being issued annually by U.S.-based banks.

With data and charts, the report demonstrates that the leveraged-loan bubble has the three characteristics which bank regulators recognize as constituting a dangerous bubble of debt. The first is very rapid growth (charts show the bubble going from $200 billion issued in 2010, to $300 billion in 2011, to $450 billion in 2012 — already surpassing the pre-crash level of issuance — to $600 billion issued in 2013 and $325 billion in first half of 2014). The second characteristic is the loosening and elimination of bond covenants, which are the stipulations within bond contracts which specify what payments of principle and interest must be made and when, in order to avoid a state of default. Some 45% of leveraged bonds are now "covenant lite" or worse, compared to 20% before the crash, the report says. The third bubble feature is interest rates on these extremely high-risk bonds, falling to rates near those for triple-A rated corporate bonds. This also has occurred, with leveraged-loan rates falling from an average of 7% in 2012 to 5% average now — despite of spike in actual defaults on these credits in 2014, to nearly $5 billion total.