Risks To Banks Emphasized By Recent Vulnerability In Leveraged Finance Market, Report Says

The weakness in the leveraged finance market in the past few weeks emphasizes the risks faced by banks that underwrite and invest in these assets, Standard & Poor’s Ratings Services noted in a report entitled “Leveraged Finance Market Jitters Highlight Risks To Banks”.

“The jury is out on whether the correction marks a much-needed return to more rational risk-based pricing, or the beginning of a severe downturn,” said Standard & Poor’s credit analyst Richard Barnes. “Our central expectation is that activity will remain soft at least through the summer, but remain underpinned by the generally supportive economic outlook. We expect a moderate increase in corporate defaults from the current cyclical low, but a harder landing cannot be entirely ruled out,” added Mr. Barnes.

The initial change in investor sentiment came as the huge primary issuance pipeline provided an opportunity to push back the most aggressive transactions, particularly covenant-lite and payment-in-kind structures. Further impetus has come from the problems in the U.S. subprime mortgage market and the resulting spillover to other asset classes. A few high-profile leveraged finance issues have consequently been postponed, and financial sponsors chose to reprice or add covenants to others to get them away. Certain banks have sustained losses on unsold underwriting positions, but the sums involved are not material at this point.

Heightened risk sensitivity among investors has raised the possibility of further falls in prices and liquidity. Standard & Poor’s has therefore stress tested the impact of a severe downturn on banks’ risk exposures and revenues. “Our analysis shows that this would certainly be a painful scenario, but banks should be able to absorb the effects at their current rating levels,” said Mr. Barnes. A more widespread deterioration across the credit markets would cause rating pressure, however.

For some time, leveraged finance has been a focus of our rating discussions with the banks that are active in this market. They include not only the major players that underwrite the primary transactions, but also smaller banks, particularly Europeans, that invest in these assets.