In recent years, a large upsurge has been recorded in the leveraged loan market. In fact, there are various prominent financial institutions such as the International Monetary Fund (IMF), who are warning time and again about the increase in leveraged loans and the potential damage that they can do to the financial system. In addition, many business executives have also shown their concern for the issue and emphasize taking corrective actions at the earliest.
Matthew Ledvina is the MD of a London-based fintech company and regularly observes the happenings within the financial sector. Along with the opportunities and trends prevailing in the economies of different countries, he also monitors the potential dangers and threat in the lending world.
Possible Consequences of the Hike
One serious threat that leveraged loans carry is that they can result in numerous firms to go bankrupt, in case there is a downfall in the economy. In fact, looking at the current scenario, corporate debts are rising at a rapid pace along with the increase in default rates. However, the leveraged loan prices in the US have seen a decline of almost 3%since 2011 and created tension among the investors. In addition, this has also given the idea of a broader danger, which corresponds to the possible liquidity crisis.
The innumerable warnings given by the market experts went completely in vain as in January 2019 witnessed a significant rise in the leveraged loan market. However, just a month before in December 2018, S&P Loans Index indicated that the US leveraged loans have suffered a massive decline since 2011.
Due to the rebound in the leveraged loan market, investors are getting optimistic about its scope. However, they are neglecting that the expansion of leveraged loans can bring a catastrophic effect on the economy in the future. There are numerous organizations that are vulnerable and in case a recession hits, they are in no position to pay back the loans. As a result, the investors may have to lose a significant part of their fortune.
What are the Current Stats?
According to sources within the U.S., the value of the leveraged loans is estimated to be $1.3 trillion. However, the Bank of England (BoE) estimates the loan figure to be above the $2 trillion marks. Such a spatial difference in the estimations may be due to the fact that there is no definite line that separates the leveraged loans from the other forms of credit. Nonetheless, when compared with the past stats, it is pretty clear that the leveraged loans have witnessed significant growth. The 2% contribution of the leveraged loans in the total corporate debt in 2000 has now increased to a significant value of 11%.
The leveraged loan market has seen an outstanding growth, but when talking about loan quality, it has been compromised. Still, the investors are not stopping from investing money in such a risky environment. Experts suggest that the rapid growth of leveraged loans is due to the two assumptions that most investors believe in. The first assumption corresponds that the leveraged loan market can easily survive a financial crisis. Whereas the second assumption is that there is high transparency and investors can easily get all the information of the covenant related changes.
However, there are many stances that have disproved these assumptions. Statistics suggest that almost one-third of the loan collateral comprises of intangible loans. The companies can easily alter such assets and make them beyond the reach of the creditors. Consequently, it becomes hard to recover the money and investors may feel cheated.
Based on all the stats, it is pretty clear that the increasing leveraged loans are no less than a serious threat to both the economy and the financial sector of the U.S. Although a decline has been observed in the corporate bankruptcy rate, it can prove fatal in case the recession hits. The banks are less prone to the damage as compared to the investors because currently, they own only one-fifth of the total leveraged loans. Nonetheless, many financial luminaries advice to take corrective steps at the earliest to improve the quality of leveraged loans and to decrease the possible damage that can occur in the future.
Check out Matthew Ledvina’s website at https://www.matthewledvina.com/.
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