And Now Defaulted Leveraged Loans Go Kaboom, by Wolf Richter

And the debt deflation beat goes on. From Wolf Richter at wolfstreet.com:

“It’s been a rotten year for distressed and defaulted loan paper.” That’s how S&P Capital IQ LCD starts out its report on leveraged loans.

“Rotten” may be a euphemism. So far, 2015 has been the worst year for defaulted “leveraged loans” since 2008 when the US financial system imploded under its own excesses.

Leveraged loans are the loan-equivalent to junk bonds. They’re issued by junk-rated over-indebted companies often to fund M&A – such as the loans issued by junk-rated, over-indebted Valeant – or to pay a special dividend to the private equity firms that own the companies, which is a form of financial strip-mining. They’re an $800-billion market and trade like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them. This gives issuers and banks a lot of leeway.

Leveraged loans are too risky for banks to keep on their balance sheet. Instead, they sell them to loan mutual funds or ETFs so that they can be moved into conservative retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.

But banks can get stuck with them when markets come out of their euphoria, as they did during the Financial Crisis. So the Fed and other regulators have been exhorting banks for two years to back off. With some success: issuance has started to decline.

The “reach for yield” over the past few years, in an environment where the Fed’s zero-interest-rate policies have repressed yield, has turned investors into blind daredevils, taking on huge risks for ludicrously low returns. This allowed companies to issue leveraged loans at very low interest rates and as “covenant-lite,” with few of the protections that investors demand during saner times.

Even the Fed has fretted about “reach for yield” in numerous statements. It’s one of the most efficient wealth transfer mechanisms known to mankind. Wall Street knows exactly how to use it.

To continue reading: And Now Defaulted Leveraged Loans Go Kaboom

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