On one side are major banks, which are diving back into high-risk corporate lending now that U.S. regulators have loosened up.
On the other are so-called shadow lenders -- private equity shops, boutique banks and other financial players that muscled in on this business when regulators restrained the big banks five years ago.
The result: ever-growing competition to provide junk-rated debt used in corporate takeovers.
It could turn out to be a “race to the bottom,” said Frank Ossino, a senior portfolio manager at Newfleet Asset Management in Hartford, Connecticut.
For the $2.3 trillion-plus market in junk bonds and leveraged loans, the question is whether all this competition ultimately brings new, greater risks.
Underwriters have already been piling more and more leverage onto companies and watering down various protections for investors.
Much of that debt is being packaged into complicated structured investments at a pace reminiscent of the subprime boom a decade ago.
“The real test will be the market reaction and ultimate recovery if loans made by these entities begin to default,” Ossino said.
That was part of the reason the Federal Reserve and other regulators drew up guidance in 2013 to curb leverage as part of efforts to prevent a rerun of the financial crisis.
What the policy makers perhaps didn’t foresee was the extent at which the shadow banks -- funds outside their purview -- would fill the role of the big banks.
Less-regulated lenders such as private equity firm KKR & Co. Inc. and credit manager Antares Capital saw multi-fold increases in their percentage share of new U.S. leveraged loans they underwrote between 2013 and 2017, according to data compiled by Bloomberg.
So did U.S. units of Australia’s Macquarie Group and Japan’s Nomura Holdings Inc. Jefferies Group LLC, the biggest non-bank lender on the deals this year, increased its share to 6.13 percent at the end of 2017 from 3.71% four years ago.
A division of Golub Capital had 1.28 percent of the market in 2017, compared with 0.08% in 2013.
The 10 of the most closely regulated banks underwrote about 54% of new U.S. leveraged loans this year compared with about 70% in 2013, when the guidance came down, according to data compiled by Bloomberg.
Nomura, Jefferies, KKR and Macquarie all declined to comment. Golub didn’t respond to requests for comment.
“We believe that our strong client relationships and innovative financing solutions will enable us to continue to be successful in the context of any regulatory environment,” Peter Nolan, an Antares senior managing director, said in an email.
Adding to the free-for-all, a number of names not necessarily associated with junk lending have cropped up as bookrunners, such as CPPIB Credit Investments Inc., the private equity arm of the Canada Pension Plan Investment Board. CPPIB declined to comment.
“Business is going to go wherever it can to get business done and that’s wherever the regulators are not,” said Danielle DiMartino Booth, founder of Quill Intelligence and a former adviser to the Fed Bank of Dallas who also writes for Bloomberg Opinion.
Despite the influx of rival lenders, regulated banks remain dominant. They also look ready to reclaim lost ground after the need to closely adhere to the leveraged-lending guidance that effectively ceased earlier this year. Deutsche Bank AG, for example, will dedicate roughly $16 billion for non-investment-grade debt from about $12 billion previously.
The business of leveraged loans is proving lucrative. Fees collected for arranging the deals hit a record $6.6 billion in the first half of 2018, and will reach an all-time high for the year if loan issuance continues at this pace, according to Freeman Consulting Services.
The leveraged-lending guidance, from the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, cautioned that any buyout adding debt more than six times a firm’s earnings before interest, tax, depreciation and amortization would attract scrutiny.
“While guidance is not binding and should not be the basis of supervisory action alone, it can outline safe and sound banking and risk-management principles and promote transparency and consistency in supervision across banks,” said Bryan Hubbard, an OCC spokesman.
“Lending to leveraged borrowers still must be conducted in a safe and sound manner.”
That includes lenders “maintaining an appropriate level of credit-loss reserves for that risk,” he said.
The Fed declined to comment.
The FDIC didn’t respond to requests for comment.
In the past, those who pushed too far received a slap down.
Goldman Sachs was warned for a debt deal to fund a July 2016 buyout of Ultimate Fighting Championship, as did banks including Credit Suisse Group AG on a 2016 deal to buy BMC Software Inc.
Both Goldman Sachs and Credit Suisse declined to comment.
The surging involvement of shadow banks is eliciting concerns.
The Financial Stability Board, an international body, said shadow-banking assets that pose risks to the financial system grew 7.6% to $45 trillion in 2016.
The Fed suggested in a May 2017 report that because leverage had migrated to the shadow-banking system its guidance failed to reduce risk in the financial system overall.
The recent easing on guidance means the banks can be less fearful of getting slammed by authorities. As a result, a spate of deals with leverage not just above the six-times marker, but in some cases beyond seven times Ebitda, have followed.
Such highly levered deals remain on the rare side, at least for now.
“Deals are getting done at leverage levels that regulated banks wouldn’t have done a year ago,” said Richard Farley of law firm Kramer Levin Naftalis & Frankel LLP.
Regulators have remained watchful, Farley said. The six-times ratio was meant to be a yardstick rather than an absolute ceiling, and only one way regulators keep an eye on the market.
Other considerations, such as a company’s ability to pay down debt and generate cash flow, remain in place.
And when regulated banks sold off loans to non-banks as they often do, those still have to adhere to the same safety and soundness principles.
“The regulators have plenty of tools,” Farley said.
“Just because there’s no speed limit on the road doesn’t mean they can’t write you a ticket for reckless driving.”