Alliance Partners’ Response to the Shared National Credit Program 1st and 3rd Quarter 2019 Reviews

Categories: Industry Knowledge

In January, the three bank regulatory institutions issued the Shared National Credit (“SNC”) Program results for the 1st and 3rd quarters of 2019 (the “Report”).  As an overview, the SNC Program is an interagency review process and an assessment of risk in the largest and most complex credits shared by multiple regulated financial institutions. The SNC Program is governed by an interagency agreement among the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (the agencies). The program began in 1977 to review credits with minimum aggregate loan commitments totaling $20 million or more that were shared by two or more regulated financial institutions (banks). A program modification in 1998 increased the minimum number of regulated financial institutions from two to three. To adjust for inflation and changes in average loan size, the agencies increased the minimum aggregate loan commitment threshold from $20 million to $100 million effective January 1, 2018.

The Report highlighted that credit risk associated with leveraged lending remains elevated.  The Report further stated that:

“Many leveraged loan transactions possess weak structures.  Underwriting risks are often layered and include some combination of high leverage, aggressive repayment assumptions, weakened covenants, or permissive borrowing terms that allow borrowers to draw on incremental facilities and further increase debt levels. Many of these credit risk factors are market driven and were not materially present in previous downturns. The agencies are focused on assessing the impact of layered risks in leveraged lending transactions and on determining whether bank risk management practices continue to evolve to address emerging risks.”

There are several points that Alliance Partners’ (“AP”) would highlight to address these findings:

  • The Report addresses underlying credit risks, but then immediately mitigates the findings by stating:

“Agent banks’ risk management practices for leveraged loan commitments have improved since 2013. Agent banks are better equipped to assess borrower repayment capacity and estimate enterprise valuations while having improved other risk management practices. While most agent banks have implemented risk limit frameworks, these frameworks have not been tested by an economic downturn.” 

While loans originated since 2009 have not been tested by a sustained economic downturn[1], many tools have been implemented by the Interagency Leveraged Lending Guidance to improve the underwriting and monitoring framework.  In addition, AP selectively underwrites all loans and applies its independent judgement on repayment capacity and enterprise valuation. 

  • The Report discusses the volume of the leveraged lending market and the potential for lower recovery rates:

“The volume of leveraged transactions exhibiting these layered risks has increased significantly over the past several years as strong investor demand has enabled borrowers to obtain less restrictive terms. Given the accumulated risks in these transactions, a material downturn in the economy could result in a significant increase in classified exposures and higher losses.”

AP has addressed both the growth of the leveraged loan market and the aspect of recovery rates in the next downturn in two recent articles:

Analysis of the Recent Moody’s Study on Leveraged Lending Recovery Rates

Recent Coverage of Growth in Leveraged Lending Market

In summary, the leveraged lending market has been leading growth on a percentage basis compared to other assets; however, leveraged lending is still dwarfed by the size of the investment grade debt market and the mortgage debt market. This increase in growth on a percentage basis has drawn the scrutiny of the regulators. Most of the growth in leveraged loans is in the broadly syndicated space where terms are getting stretched by an influx of investor capital.  It should be noted that AP typically invests in middle market loans which generally have a lower leverage profile than that of broadly syndicated loans. While overall market leverage is increasing, it should also be noted that equity contributions have also consistently grown since the previous downturn, which provides more support to the capital structure in the event of value erosion. Lastly, it should be noted that the broader economy has enjoyed 10 years of robust growth[2] and the leveraged lending market has experienced a low default environment relative to the long term average[3]. A material downturn in the economy would likely not just impact leveraged loans with overly aggressive credit structures but would impact all asset classes.  The fact that a material downturn would lead to increased classified exposures and potentially higher losses seems to be a fairly obvious conclusion.

  • The Report identifies the proliferation of non-bank lenders and their appetite for risk with the following passage:

“In addition, nonbank entities continue to participate in the leveraged lending market as these firms seek credit exposure via loan purchases. These nonbank entities hold a significant portion of non-pass leveraged SNC commitments and mostly non-investment grade equivalent SNC leveraged term loans.” 

AP has observed the increase in non-bank lenders as well as the overall increase in total leverage.  The market has seemed to bifurcate into loans originated by non-regulated institutions with higher multiples and unique structures, and loans originated by regulated institutions with more conservative structures.  In addition, unitranche facilities have gained in popularity which have “stretched” senior multiples to record highs.  To address this, AP has selectively worked with a wide variety of origination Agents, with the vast majority being regulated institutions that must adhere to the Interagency Leveraged Lending Guidance.  AP’s leverage profile typically is lower than the market as it selectively looks at leverage and adheres to the Risk Acceptance Criteria (“RAC”) set by BancAlliance (“BA”).

  • The Report highlights a multitude of loose structural terms, including aggressive repayment assumptions, weakened covenants, or unconstrained incremental facilities. 

BA recently commissioned a third-party loan review completed by Strategic Risk Associates (“SRA”) for loans originated by AP.  SRA commented in their summary:

“Emerging Risk/Forward Looking Indicators: BA has maintained traditional loan structure safeguards. There are currently no Cov-Lite loans in the BA portfolio and no pre-committed free and clear incremental loans. Any free and clear incremental loans existing in the portfolio are subject to the financial covenants (typically the then outstanding leverage covenant at least on pro-forma basis), which is consistent with free and clears in the market. The free and clear incremental loans in the portfolio still require commitments from lenders, but not all lenders have to commit for it to get done. By avoiding loans with these structures, BA has reduced the portfolio impact these emerging risks may have on future credit performance.”

Conclusion:  The SNC Report highlights that some leveraged loans have increasingly aggressive structures, which could be problematic in a downturn.  While true, this statement may apply in varying degrees to the leveraged lending market at large, where loan structures and Borrowers are not homogenous.  The Report also mitigates its claims by pointing out that banks have improved their risk management processes with respect to underwriting and monitoring.  In fact, the Report addresses that most of the risk is being offered and supported by non-bank lenders. AP continues to selectively screen, diligently underwrite and actively monitor loans that are acceptable to the BancAlliance RAC and appropriate for regulated institutions. 

[1] The National Bureau of Economic Research – US Business Cycle Expansions and Contractions.  https://www.nber.org/cycles/US_Business_Cycle_Expansions_and_Contractions_20120423.pdf

[2] The National Bureau of Economic Research – US Business Cycle Expansions and Contractions.  https://www.nber.org/cycles/US_Business_Cycle_Expansions_and_Contractions_20120423.pdf

[3] Standard & Poor’s Leveraged Commentary and Data.  LCD Quarterly Review.  Fourth quarter 2019.