Imagine a trillion-dollar market that runs on faxes and phonecalls while routinely tying up investors' money for months beforethey get any return.

That's not fiction: It's the unregulated market for leveragedcorporate loans. In a financial system that is increasinglyautomated, the origination and trading of loans is in the relativedark ages while money pours in from mainstream investors such asKansas and New York pension plans and mutual funds catering toindividuals seeking high yields in an era of near-zero interestrates.

The antiquated structure of a market that's ballooned from amere $35 billion in 1997 poses a growing threat, raising the oddsof gridlock in a downturn when investors expect to get their moneyback with a click of a button. As of yet, no regulators have takenresponsibility for fixing the deficiency.

“It's a critical issue,” said Beth MacLean, a moneymanager at Newport Beach, California-based Pacific InvestmentManagement Co. (Pimco), which oversees $1.97 trillion, includingthe world's biggest bond mutual fund. “Any single retail fund notbeing able to meet their redemptions would have a ripple effect onthe whole market.”

The time it takes to settle a loan has gotten worse since thefinancial crisis, lengthening to an average 20 days as of June,from 17.8 days in 2007, according to data tracked by the LoanSyndications and Trading Association. In the high-yield bondmarket, it generally takes three or fewer days.

When regulators were drafting securities laws more than 70 yearsago, company loans were excluded because they were mainly privatetransactions between one bank and one borrower. That's no longerthe case, as the debt is mostly syndicated, or distributed, toinvestors who can then trade the loans among themselves like a bondor a stock.

Judith Burns, a spokeswoman for the U.S. Securities and ExchangeCommission, which has placed a priority on monitoring corporate andmunicipal bond trading more closely, declined to comment. So didrepresentatives of the Federal Reserve, the Office of theComptroller of the Currency, and the Federal Deposit InsuranceCorp.—which have all raised concern that banks are being too lax intheir loan underwriting standards.

The logjam in the modern syndicated-loan market, founded in 1982by JPMorgan Chase & Co. Vice Chairman James B. Lee Jr., mattersto more people than ever.

Riskier Things

Investors poured an unprecedented $62.9 billion last year intomutual funds that buy the debt, which is mostly speculative-grade,according to Lipper data. They have been lured by yields greaterthan those of higher-rated securities and interest payments thatfloat above benchmark rates—with the latter being an attractivefeature amid speculation the Fed may boost borrowing costs nextyear.

Mutual funds bought 32 percent of new loans last year, up from15 percent in 2012, LSTA data show. The New York City Employees'Retirement System held about $961.8 million as of March 31,regulatory filings show.

“Pension and retirement funds have poured in for the reason youknow: They need yield,” said Erik Gordon, professor at the RossSchool of Business at the University of Michigan in Ann Arbor. Thelow-rate environment has “forced people's retirement to be investedin riskier and riskier things, and this is an example of a riskierthing.”

Some of the worst delays in settlement times can be found in themarket for new loans, where Pimco's MacLean said it's not uncommonfor months to pass before a purchase is completed.

Investors committed $1.2 billion in October to fund a loan forjunk-rated Huntsman Corp. For about 10 months, they didn't receivea dime.

Salt Lake City-based Huntsman obtained the financing to help payfor its purchase of Rockwood Holdings Inc.'s titanium dioxidebusiness. The merger has taken longer than anticipated because ofan antitrust holdup.

Kurt Ogden, a vice president of investor relations at Huntsman,said last month the loan commitment has been extended through Dec.17. Investors were paid a fee in August, at which time the companyalso started putting aside interest that they'd receive uponsettlement, said spokesman Brad Hart.

While the delays wouldn't happen in a bond offering, it'spermissible in the loan market, where each financing is craftedaccording to individual borrowers' desires.

Archaic System

One reason there's little momentum to streamline trading is thatWall Street banks benefit from the status quo, according to ScottPage, director of bank loans at Boston-based mutual fund firm EatonVance Corp. Banks earn fees for committing to fund deals until theyclose while shifting risk to investors.

“The biggest banks, who act as underwriters, have an apparentself-interest in maintaining this archaic system,” Page said. “Weare mystified by the fact they seem to have no interest in fixingit.”

JPMorgan and Bank of America Corp., the two biggestunderwriters, as well as other big banks, typically earn fees of 1percent to 5 percent for arranging a leveraged loan, according toStandard & Poor's data. That compares with 0.5 percentage pointon bonds for investment-grade companies, and 1.3 percent for junknotes last year, Bloomberg data show.

While buyers and sellers can trade stocks and bonds amongthemselves, they need the approval of corporate borrowers beforethey can exchange loans. Clerks must then update loan documents toreflect new lenders.

With loans, “there's a high amount of faxing going on still,”said Virginie O'Shea, a senior analyst at Aite Group LLC in London.“People don't realize that fax machines are still around in thisday and age, but they are.”

Banks have no incentive to drag out the time it takes to settlea loan, according to Bram Smith, executive director of the NewYork-based LSTA, the market's main lobbying group.

“It's a well-known fact to market participants that loansettlement is different from that of other asset classes,” he said.By recognizing the difference, both mutual funds and otherinvestors have “prospered and grown quite nicely.”

Brian Marchiony, a spokesman for New York-based JPMorgan, andZia Ahmed, a spokesman for Charlotte, North Carolina-based Bank ofAmerica, declined to comment.

Less Liquid

While loans may be inefficient to process, their ability to becrafted for unique financing situations is what makes themattractive to many borrowers and lenders, the LSTA's Smithsaid.

Wall Street's biggest banks have helped speculative-gradecompanies including cable-television provider CharterCommunications Inc. and hospital operator Community Health SystemsInc., raise $405 billion this year through loans that weredistributed among investors, data compiled by Bloomberg show.That's the fastest pace ever.

“Bank loans are a popular topic these days—a source of stablereturns, less risk to rising interest rates,” Dennis MacKee, arepresentative of the Florida State Board of Administration, wrotein an e-mailed response to questions. “In return, there is atrade-off of some liquidity.”

The Kansas Public Employees Retirement System board of trusteesagreed in May to commit $100 million to a strategy focused onhigh-yield bonds and leveraged loans.

The concern is that there may be a mass exodus from mutual fundsthat could strain the loan market as investors anticipate risingborrowing costs and defaults. Mutual funds and exchange-tradedfunds settle investors' redemption requests within three to sevendays, according to Moody's Investors Service data.

“There's kind of a liquidity mismatch,” the University ofMichigan's Gordon said. When investors try to redeem and can't gettheir money back right away, more will try to pull cash, risking arun, he said.

The expense to investors resulting from a paper-based market'sinefficiencies stretch beyond missed payments. The market caneasily turn in a month, leaving investors funding deals atyesterday's rates.

The 1.19 percent decline in loan prices since the end of Junesuggests that buyers of $1 billion of loans at rates set then wouldbe overpaying by $11.9 million if the deal closed now, based onS&P and LSTA index data. Prices have declined 0.51 percent thismonth, to 97.8 cents on the dollar

Investors have started to push back, demanding fees on loansthat fail to settle within a designated period, often a month ormore, Bloomberg data show.

“The longer the wait, the greater the danger of a problem” forinvestors, former SEC Chairman Arthur Levitt said in a telephoneinterview.

Levitt, who is on the board of Bloomberg News parent BloombergLP, warned more than a decade ago that debt traders and bankersneeded to shrink the time it took to complete trades.

The labor-intensive process of settling a loan trade requiresbanks to maintain teams of back-office staff at a time when they'reeliminating jobs to boost profitability.

JPMorgan charges a $3,500 fee for each trade made by investorswho exchange debt it helped distribute with competing firms, peoplewith knowledge of the matter told Bloomberg News earlier thisyear.

Those types of fees would decline or disappear if the debt fellunder securities rules, according to Elisabeth de Fontenay, a DukeLaw School professor in Durham, North Carolina, who previouslyworked as a corporate lawyer at Ropes & Gray LLP.

Fund Flows

There are other costs to investors. Fund managers often pay tomaintain credit lines they can draw upon to meet redemptions andhold extra cash to mitigate the risk they'll be unable to quicklysell underlying loan holdings.

“Should investor flows reverse, the mismatch in bank-loan fundscould pose a material risk,” Moody's analysts led by Stephen Tuwrote in a July 7 report.

While mutual-fund investors have started souring on the loans,pulling $4.7 billion this year, other institutions have continuedto amass record amounts of money to buy the debt.

Firms from Apollo Global Management LLC to GSO Capital PartnersLP raised an unprecedented $60.7 billion in the first half of 2014for collateralized loan obligations, which pool loans and slicethem into pieces of varying risk and return.

“It's a very complex, very large challenge requiring theconsensus of market participants, including, in some cases, theborrower,” LSTA representative Howard Moore said in an e-mail.“Progress has been slower than we wanted, but the LSTA and itsmembers are committed to improving the settlement process.”

Without pressure from regulators, Wall Street's biggest bankshaven't yet overhauled the market. They've been cutting hundreds ofthousands of jobs to reduce costs as they face stricter regulationsintended to help prevent another crisis.

“You have to believe having an archaic system break wouldultimately be more expensive for everyone, including the agentbanks,” Eaton Vance's Page said. “Many people have approached them,and they have no interest” in fixing the problem.

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