There’s been a steady drumbeat of warnings about a surge in risky corporate borrowing—but not much clarity about how serious the threat is. At issue is the more than $1 trillion market in leveraged loans. That’s Wall Street jargon for high-interest loans to business with less than rock-solid finances. Federal Reserve and European Central Bank officials have drawn attention to the rise in corporate debt and the deterioration of lending standards. The loans are often bundled into securities known as collateralized loan obligations (CLOs).
Most of the watchdogs are careful to say a repeat of the 2007-2008 crisis is unlikely because most of the debt isn’t held by banks. But that creates another problem: Regulators focused on banks are largely in the dark when it comes to pinpointing where the risks lie and how they might ripple through the financial system when the economy turns down. A big worry is that over-indebted businesses could face severe stress and, in some cases, insolvency, threatening jobs and deepening the next downturn. “I always remind myself that even the smartest policymaker with the most far-reaching perspective, data, and tools was basically blindsided by the breadth and depth of the housing crisis,” says Mark Spindel, chief investment officer at Potomac River Capital. “Leveraged loans and corporate debt are not housing, but maybe it’s more pervasive than we think.”
The mechanics of the levera