Leveraged Lending Envy: Banks and Non Banks

Bankers and their supporters continue to object to regulatory leveraged loan leverage limits. The limits raise concern whenever transaction related Funded Debt to EBITDA ratios exceeds 6X. The usual complaints include:

1)     The Market and Bankers know what is best-not regulators

2)     Regulators are keeping banks from lucrative lending opportunities

3)     The lucrative opportunities will be picked up by less regulated non banks like business development companies (BDC)

4)     The restrictions are inhibiting the LBO market development and growth

Let’s take a look at these complaints:

1)     Market knows best: The tragedy of commons shows that some market equilibrium can lead to suboptimal results. Look at the concentrations(leveraged loan commitments YE 2007):

Merrill: $97B

Citigroup: $97B

JPMorgan: $95B

Goldman: $95B

2)     Loss of lucrative loans: lucrative loans usually have more risk than acknowledged. Consider leveraged loan 1Q08 provisions and charges for some of the major players:

Merrill Lynch: $1B; contributor in its forced sale to BofA

Citigroup: $2.6B; contributor in its subsequent failure and rescue

BofA: $700Mln; contributor to its need to be rescued

JPMorgan Chase: $1.4B

Wachovia: $500MLn; contributor to forced sale to Wells

3)     As I previously discussed-this is really a work in process whose outcome remains to be seen. Nonetheless, just because someone else is doing something stupid doesn’t mean tax payer guaranteed banks should follow them off the cliff. Private capital not subsidized by tax payers should be free to invest at whatever leverage levels they chose. Furthermore, bankers seeking BDC lending flexibility should keep in mind it comes with BDC capitalization levels which have substantially less leverage than banks. Sorry boys, you cannot pick and chose the good BDC features without taking the bad.

4)     Restricting the LBO Market: PE may complain that the restrictions reduce the availability of under priced bank loans. The response- is that so bad? Also, remember the restrictions focus on leverage greater than 6X. If you need more than 6X to make the deal work, then maybe the deal is overpriced.

The leveraged loan market, like other deal markets, such as real estate, is prone to boom and bust cycles. Lenders fixate on nominal not risk adjusted return as they are driven by incentive compensation to maximize their bonuses. Regulators trying to stop them face the same plight as someone trying to stop an individual from playing Russian Roulette who is on a winning streak. When that individual is subsidized by tax payers, as banks are, then it does not seem too much to ask to place some restrictions on leverage levels. The banks should be thanking the regulators for stopping them from hurting themselves.

J