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We see financial crises coming, like approaching storms. We see the clouds, but we may fail to properly judge the severity they forebode. Such is the case with leveraged loans.

The 2008-2009 financial crisis

Let’s take the 2008-2009 financial crisis. Households were borrowing too much, subprime mortgages had been identified as being problematic, and everyone had heard about “liar” loans. The issues were well-known, but one had to make a judgment about severity. Former Fed Chair Ben Bernanke expected that a blow-up of the subprime sector of the mortgage market could be contained. In a May 2007 speech he confidently stated: “[T]he effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system”.1 After all, the subprime mortgage market was only a small slice2 of the mortgage market.

Not a big problem was Bernanke’s verdict.

Present situation

We face a situation where business debt is at historic highs relative to the size of the economy. And the recent growth in business debt has been concentrated in riskier forms of debt: Leveraged loans, often repackaged into collateralized loan obligations (CLOs).3

Last November, Senator Elizabeth Warren voiced her concerns about leveraged lending activities in a letter addressed to the Secretary of the Treasury, the chairs of the Federal Reserve Board, the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, as well as to the Office of the Comptroller of the Currency.4 “I am concerned that the large leveraged lending market exhibits many of the characteristics of the pre-2008 subprime mortgage market. These loans are generally poorly underwritten and include few protections for lenders and investors. Many of the loans are securitized and sold to investors, spreading the risk of default throughout the system and allowing the loan originators to pass the risk of poor underwriting on to investors.”