Financial Stability Oversight Council Is Missing an Opportunity to Enhance Preparedness and Response to Financial Stability Risks

Financial Stability Oversight Council Is Missing an Opportunity to Enhance Preparedness and Response to Financial Stability Risks

By Mayra Rodriguez Valladares, MRV Associates
Originally published in Forbes

In analyzing the leveraged lending and Collateralized Loan Obligation (CLO) markets, the U.S. Government Accountability Office found there are more opportunities for the Financial Stability Oversight Council (FSOC) to prepare and respond to financial stability threats. FSOC has been monitoring risks that arise in the leveraged lending market, through its monthly Systemic Risk Committee meetings. In its report released today, the GAO stated that “FSOC does not conduct tabletop or similar scenario-based exercises where participants discuss roles and responses to hypothetical emergency scenarios. As a result, FSOC is missing an opportunity to enhance preparedness and test members’ coordinated response to financial stability risks.” Thus far, FSOC has not publicly agreed with the GAO’s recommendation to conduct tabletop exercises.

Additionally, the GAO reiterated as it had in 2016, that “FSOC does not generally have clear authority to address broader risks that are not specific to a particular financial entity, such as risks from leveraged lending. The GAO recommended that “Congress should consider better aligning FSOC’s authorities with its mission to respond to systemic risks.” Unfortunately, as of today, Congress has not followed GAO’s recommendation.

FSOC is tasked with responding to systemic risks, but according to the GAO, “it may lack the tools needed to do so comprehensively, particularly when the risks stem from broad-based activities like leveraged lending that involve a range of bank and nonbank participants overseen by multiple financial regulators.” GAO argues that changes such as broader designation authority would help FSOC respond to risks from activities that involve many regulators, such as leveraged lending. This is particularly important, because the three national bank regulators, the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Company, along with the Securities and Exchange Commission all share responsibilities over supervising financial and non-financial companies involved in the leveraged lending market; moreover state financial regulators also supervise banks and non-banks in their states, which are in these markets as leveraged loan originators, sellers, and investors in collateralized loan obligations.

The GAO analysis also found that regulators do not identify leveraged lending as a significant threat to financial stability. Nonetheless risks remain, especially as the COVID-19 crisis continues to pressure leveraged companies’ ability to stay current on their loan payments. Before the COVID-19 crisis and this year, I published over 35 articles citing my concerns about the potential adverse impact to banks, other lenders, and investors from weak underwriting practices for and lite covenants in leveraged loans and collateralized loan obligations.

An area I continue to be worried about are companies’ rosy assumptions about their Earnings Before Interest Tax and Depreciation (EBITDA). According to the Office of Financial Research (OFR), earnings adjustments (also called EBITDA add-backs) often took “the form of projected cost savings added back to profits for the purpose of increasing projected profits and lowering the borrower’s leverage, or debt-to-EBITDA ratio.” The Financial Stability Board has stated that these add-backs “were generally uncertain, in both magnitude and timing, and may overstate a borrower’s EBITDA and thus understate its leverage.” Standard and Poor’s in a review of companies’ EBITDA adjustments for 31 transactions in 2016 showed that, on average, the companies’ projections were over 30% higher than their actual EBITDA.

When COVID-19 struck, credit rating agency downgrades of leveraged loan downgrades hit record highs; moreover, defaults across most sectors of the economy increased significantly. In contrast, the GAO found that as of September 30, 2020, “senior CLO securities had generally retained their ratings, and the leveraged loan and CLO markets appeared to be recovering.”  Additionally, according to the GAO “based on the Federal Reserve and SEC staff’s assessments, post COVID-19 shock asset sales from mutual funds that invest primarily in leveraged loans may have contributed to downward pressure on loan prices in an already declining market but had not posed a significant threat to financial stability as of September 30, 2020.”

While I am very pleased that leveraged loans and CLOs do not presently present a threat to financial stability, I continue to encourage bank regulators, the SEC, and FSOC to obtain more data about the interconnections between non-banks and banks in leveraged lending and CLO transactions. There continues to be a lot of opacity in these markets which makes it challenging for investors, regulators and taxpayers to get a full view of how risks in these markets could end up impacting the financial system and taxpayers. The U.S. GAO staff certainly deserve praise for all the effort and time that they expended on this important analysis.

Originally published in Forbes

This column does not necessarily reflect the views or opinions of FinReg Alert or Tradeweb Markets LLC.