How regulators, Republicans and big banks fought for a sharp rise in lucrative but risky business loans

One of their main goals was leveraged loans. These are huge loans that banks give to highly indebted companies – in financial terms and heavily indebted -. Bankers often have little assurance that loans can be repaid, making them particularly risky. Bankers earn large commissions on these products, and many bank executives say their institutions are safe from loss because they sell loans to other investors, such as hedge funds, mutual funds and insurance companies.

By releasing banks for them to make more loans, regulators have allowed more money to be injected into the economy. White House officials say this has allowed President Trump to achieve the goal of faster economic growth in the first half of his term.

This article is based on interviews with 31 bank regulators, past and present, senior administration officials, congressional aides, bankers, and market analysts. Some of them talked about the condition of anonymity to discuss the internal deliberations of the government.

Most admitted that they had no idea what would happen to the economy in case of default of these loans.

This tension between easy money and unknown risks has puzzled some of the officials who have let the loans wrap up since 2017. In an appendix of its annual budget, White House officials discussed in March the leveraged loan earnings and the potential that they could cause a repeat of the financial crisis in 2008 and 2009.

"The loans have increased, which is a positive development, but we must ensure that excessive debt and risk do not repeat the mistakes of the 2000s," says the report.

A warning to banks

In 2011, two years after the end of the financial crisis, an experienced bank examiner felt he had seen a worrying trend.

Banks were reverting to a type of risky risk credit called a leveraged loan.

The official, Timothy Long, was the chief examiner of the National Bank at the Office of the Controller of Money (OCC). He warned other reviewers to remain vigilant and prevent banks from taking too much risk with these loans.

During an interview, banks have long been attracted by leveraged borrowings because of the huge costs they could earn.

But these loans are high risk. They are intended for borrowers who have access to less money than others and who tend to be more late in paying when interest rates rise or the economy slows.

"In the last 35 years, it's the bank's worst loans," said Long.

He retired a long time later in 2011. Two years later, the OCC, along with the Federal Reserve and the Federal Deposit Insurance Corp., the leading banking regulators, issued an official "guideline" intended to remove the banks from the riskiest of these loans, thus reinforcing Long's warnings. in a firmer policy.

"In particular, financial institutions should be careful not to unnecessarily increase risks by borrowing badly subscribed loans," wrote the regulators. "[A] leveraged loan badly subscribed. . . can generate risks for the financial system. "

Although the "directive" is not an order that obliges banks to act in a certain way, companies have always complied with it, as they try to avoid conflicts with them. regulators.

The instructions are not the only warning issued by the regulators.

In a report the following year, regulators revealed "serious loopholes" in the way leveraged loans were offered by banks. She found that 31% of loans offered by banks in the last 12 months were considered "low", which means that they are poorly executed and present a high risk of default. It also revealed that 75% of all non-compliant banking sector assets were leveraged loans.

In addition, the US Federal Reserve warned Credit Suisse that it should be more cautious about risky leveraged loans, according to media reports.

Karina Byrne, a Credit Suisse spokesperson, said the company "did not comment on any of our specific interactions with our regulators."

This new regulatory push has thrilled the banking sector. Financial companies have recalled their leveraged loans, according to industry data. The issuance of these loans increased from $ 607 billion in 2013 to $ 423 billion in 2015, according to S & P Global Market Intelligence. Private equity firms complained that it was more difficult to obtain loans for debt buybacks.

Bankers, worried about losing millions of dollars in fees, began to complain to congressional regulators and advisers that regulatory "guidelines" should not dictate how banks do business.

Prior to the 2016 elections, bankers had informed congressional regulators and advisers that their banks simply wanted to obtain the loans and then sell the risk to investors, such as insurance companies and mutual funds. Bankers argued that even if the loans were risky, federally insured banks would not lose anything if the loans went south because they had sold the products to others, according to five leaders of the bank. banking sector involved in the discussions.

The biggest opposition to the guidelines was made by a trade association called the Clearing House Association, whose members include JP Morgan Chase, Wells Fargo and Bank of America, said these people. Last year, the Clearing House Association merged with another entity and formed a group called Bank Policy Institute. Chief Executive Greg Baer refused to comment.

Over the course of several months in 2017, a series of events demystified the past efforts of regulators.

In March 2017, two months after the inauguration of Trump, Senator Patrick J. Toomey (R-Pa.) Sent a letter to the Government Accountability Office requesting a legal ruling on whether the 2013 guidelines should have been classified as a "rule".

This designation mattered because Congress had the power to repeal a "rule" with a majority vote and Republicans in Congress would quickly cancel multiple settlements with this tactic.

Toomey is one of the highest voices in the Senate calling for greater banking deregulation. Ten of the seventeen most important contributors to his campaign are heads of financial companies.

In an interview, Toomey said that no financial company had contacted him about the problem of leveraged loans. Instead, he stated that his collaborators had identified him as a blatant example of the kind of overbreadth of regulation that he had long fought over to curb.

"This comes first and foremost in the context of a broader effort on my part to reduce the. . . the quasi-omnipotence of some regulators and restore the legislative authority to which it belongs, which is the Congress, "said Toomey.

Less than two months later, Trump replaced Thomas Curry, appointed by President Barack Obama to head OCC, along with bank lawyer Keith Noreika.

In June 2017, Treasury Secretary Steven Mnuchin released a 149-page report calling for changes in the way financial companies are overseen by the government. Among them, the Treasury report indicates that banks have found the guidelines confused, which is one of the reasons they have reduced their lending.

The Treasury urged the agencies to effectively suspend the guidelines and publish them again, this time to get more comments from the banks. These loans are essential for economic growth and the provision of credit to companies that would otherwise not have access to these funds, says the Treasury report. Treasury officials met with bankers and other people when preparing the report, although their role in formulating the final version is unclear.

In October 2017, the GAO issued a report claiming that the 2013 "guidelines" should have been published more formally, a position that raises the possibility of invalidating the regulators' power.

The following month, Rep. Blaine Luetkemeyer (R-Mo.), Then chair of the House Subcommittee on Financial Institutions and Consumer Credit, sent a letter to regulators asking them to ensure that they were "safe". they would not comply with the leveraged loan guidelines.

A few days later, Noreika told the Wall Street Journal that leverage loan guidelines "should not bind anyone." Noreika, who has returned to the private sector and advises financial companies, among others, declined to comment.

& # 39; Khan's anger & # 39;

The valves were only beginning to open.

Noreika's alternate at OCC was Joseph Otting, a financial executive and former colleague of Mnuchin. In early 2018, Mr. Otting said at a conference of investors in Las Vegas that banks, in terms of leveraged loans, "have the right to do what you want, to provided it does not affect security and stability, it is not our position to challenge that. "

He underlined all the tightening felt after the publication of the 2013 guidelines: "It was as if people feared to cross the line without feeling Khan's anger against the regulators," he said, according to a statement. Reuters report published at the time. .

The remarks surprised some regulators of other banking agencies, because they were worried about the bankers dive into high-risk business lending, according to two people involved in the discussions, who spoke on condition of anonymity because they were not allowed to reveal the internal deliberations of the agencies.

Long, the former senior official of the OCC, said that many of his former colleagues and himself felt that while the US economy was entering its tenth year of growth, this n & # 39; It was a matter of time before a slowdown started and many of these loans were not deteriorating. When companies default on their loans, bankers often retire and refuse to lend as freely, fearing to extend the funds to other companies that might also default. This can quickly affect the entire economy, leading to layoffs and bankruptcies, as well as stopping new investments.

"We are in the eighth year of a seven-year credit cycle," he said. "When things turn, they will turn very hard."

"Someone's going to get hurt over there"

As regulators reduced controls, bankers began to stuff themselves.

Financial companies issued a total of $ 1.271 trillion in leveraged loans in 2017 and 2018, 40% more than in 2015 and 2016, according to S & P Global Market Intelligence. More than 80% of loans made in 2018 were contracted with fewer restrictions on the borrower and fewer protections for the lender in the event of loan default.

These loans are often central to leveraged buyouts by private equity firms when they take over a business in difficulty that is in danger of bankruptcy.

In recent years, personalities such as J. Crew, PetSmart, Neiman Marcus, Buffalo Wild Wings and Nine West have all been restructured with leveraged loans. There are hundreds of other cases, including energy and health care companies, many of which have received multibillion dollar loans from a consortium of banks and private companies. other lenders.

Asked about his exposure to leveraged debt, JPMorgan Chase chief executive Jamie Dimon told analysts in January that banks were much more resilient – and smarter – than 10 years ago. He acknowledged that some financial companies, especially those that are not banks, could lose money during a recession because of these products, but he expected that the company would not be able to afford it. impact is limited.

"Someone's going to be hurt there," he said.

Bank of America CEO Brian Moynihan had a similar opinion on the expected results of his business this month. He stated that his company took out a number of these loans but sold them immediately, indicating that they had no risk on their balance sheets.

"We are marketing and moving them, and everything is gone," he said.

One reason that bankers have been able to contract so many of these higher risk loans without regulatory interference is that they sell these products to outside investors. Loans are grouped into products called collateralized loan obligations, or CLOs.

The CLO market has grown over the last 10 years, from $ 300 billion at the end of 2008 to $ 615 billion at the end of 2018, but the quality of these products is much worse than before the financial crisis, according to the Reserve. Federal Bank of Dallas.

Some former regulators have noted a strange parallel between the sub-prime mortgage crisis and the build-up of leveraged loans. In the 2000s, banks and other finance companies borrowed at-risk – some mortgages – and packaged them into products sold to investors. Financial corporations have also manufactured other exotic instruments, called collateralized debt obligations, related to these securities. The products entangled financial companies, allowing weak institutions to overthrow stronger institutions when the value of these products has eroded.

Today, regulators say they do not have a clear idea of ​​the impact of the economy when the economy weakens or goes into recession.

"We are doing a lot of work in this area to try to better understand the risk," said Bob Phelps, OCC Assistant Supervisory Control Controller. "How it will be played … is really hard to understand."

Banking sector expands its influence

The recent reluctance to tackle leveraged borrowing is part of a broader regressions of regulation.

Fed officials, tasked with detecting the risks posed by major financial institutions to the financial system and the economy in general, announced in March a plan to reduce the process used to monitor how large banks operate. face the recession. Officials said the banks had improved their preparations for the next economic slowdown. Lael Brainard, a member of the Fed's board of governors and appointed at the time of Obama, was the only Fed official to vote against that decision. The others who voted for him were appointed by Trump.

In November, Senator Elizabeth Warren (D-Mass.) Asked Randal Quarles, Vice President of the Fed for Banking Supervision, if regulators were doing enough to tackle the record level of leveraged loans . She asked why the 2013 forecast was not monitored as it was five years ago.

Quarles said the Fed was more appropriate to determine if banks posed a risk to the financial system.

"We're watching for safety and soundness," Quarles said. "We should not monitor compliance with the guidelines."

He pointed out, however, that the Fed and other regulators were monitoring the risks of leveraged borrowing, although it had not offered any valuations.

"We're looking at it quite athletically," he said, without explaining what he meant.

After making substantial progress in pushing regulators to ease the scrutiny of leveraged borrowing, the banking sector continues to expand its influence.

Last year, at Powell's request, Nellie Liang, an economist and financial regulation expert, was appointed by the White House to the Central Bank's Board of Governors.

Her appointment to the White House has been exceptional, as she has no experience in the banking sector and has already worked for the Fed to fine-tune the supervision of financial companies. She previously headed the Federal Reserve's Financial Stability Office, one of its most powerful components.

Lobbyists in the banking sector fanned the opposition against Liang, persuading some Republicans of the Senate Banking Committee to block his confirmation, according to five people involved in the process. In January, she announced that she was retiring from the list after it became apparent that she could not get confirmation from the Senate.

Trump then took a very different direction and announced plans to appoint two major political supporters, Herman Cain and Stephen Moore, to open seats at the Fed. Neither of them commented on the leveraged loans, but both are big supporters of an easing of regulation and have called for immediate action to further accelerate the growth of the bank. # 39; s economy.