More than five months ago, the Federal Reserve and Office of theComptroller of the Currency (OCC) told some of the biggest banks toimprove underwriting standards for non-investment-grade loans. Themarket is showing few signs of tightening as lenders chaselucrative fees.

Banks are arranging junk-rated deals that leave companies withdebt levels exceeding guidelines set by regulators. Among them: the$1.7 billion of loans led by UBS AG and Deutsche Bank AG last monthto finance KKR & Co.'s purchase of a majority stake in SedgwickClaims Management Services Inc., and the $700 million loan CreditSuisse Group AG arranged in January for Applied Systems Inc., amaker of software for insurance companies.

Bank supervisors are insisting on minimum standards as they seekto avoid a repeat of the losses that occurred during the creditcrisis, which sent the global speculative-grade default rate tomore than 13 percent in 2009, the highest since the GreatDepression. The persistence of deals with questionable terms showsthat, so far, regulators are having trouble deterring excessiverisk-taking simply by asking.

“Jawboning rarely works if there's money to be made,” said MarkCalabria, director of financial regulation studies at theWashington-based Cato Institute, a research group that espouseslimited government. “History doesn't repeat itself but sometimes itrhymes—I certainly have those concerns.”

Urging Prudence

Starting last September, the Fed and the OCC sent letters tobanks giving them 30 days to come up with a plan for tighterpolicies, according to four people familiar with the missives.Recipients included Barclays Plc, Citigroup Inc., Deutsche Bank,Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley,and UBS.

The Fed and OCC are urging restraint in a market that has beenone of the bright spots for banks hobbled by narrow profitmargins.

Debt-underwriting revenue at eight of the largest U.S. andEuropean investment banks, including JPMorgan and Deutsche Bank,rose 9.1 percent to about $18.7 billion in 2013. That was thehighest total since at least 2008, according to BloombergIndustries. Much of the increase last year was driven by high-yieldlending, industry analytics firm Coalition Ltd. said in its annualreport in February.

Fees for underwriting leveraged loans can be about twopercentage points, or $20 million on a $1 billion credit, accordingto two people familiar with such deals, who declined to beidentified because they're not public. That compares with anaverage of about 50 basis points, or 0.5 percentage point, forarranging investment-grade bonds last year, according to datacompiled by Bloomberg.

While banks will often use their balance sheets to commit tofinancing a leveraged loan, they typically sell them to investorssuch as mutual funds, hedge funds, or collateralized loanobligations. CLOs are a type of collateralized debt obligation thatpool high-yield loans and slice them into securities of varyingrisk and return.

Covenant-Light

Leveraged loans, also called high-yield or junk-rated loans, aremade to companies rated below Baa3 by Moody's Investors Service orlower than BBB- by Standard & Poor's.

“The big banks are crawling all over here” to make loans, andterms are “hyper-competitive,” Federal Reserve Bank of DallasPresident Richard Fisher said Feb. 12 in an interview at thedistrict bank. Because interest rates are low, “everyone isreaching to take advantage of this environment.”

For the first time, more than half of the junk-rated loans madein the U.S. during the fourth quarter and so far this year lackedstandard protections for lenders such as limits on debt relative tocash flow, Bloomberg data show. Such so-called covenant-light loansamounted to a record $84 billion in the fourth quarter. That wasfollowed by another $57 billion since December.

The exclusion of “meaningful maintenance covenants” is a signthat “prudent underwriting practices have deteriorated,” the Fed,OCC, and Federal Deposit Insurance Corp. (FDIC) said in a March 21statement accompanying the release of their underwritingguidelines.

The advisory said debt levels of more than six times earningsbefore interest, taxes, depreciation, and amortization, or Ebitda,“raises concerns.” Underwriting standards should also consider aborrower's ability to repay and “delever to a sustainable levelwithin a reasonable period,” the regulators said.

“The issuer community has continued to press the envelope,” saidJason Rosiak, head of portfolio management at Newport Beach,California-based Pacific Asset Management, the Pacific LifeInsurance Co. affiliate that oversees about $4.5 billion in assets.“Some deals” are “dialing up leverage a bit more, andcovenant-light has become the norm.”

Meredith Coffey, an executive vice president at the LoanSyndications and Trading Association, declined to comment. The NewYork-based LSTA is the leveraged-loan market's main tradegroup.

Fed officials have singled out leveraged loans as an example ofexcessive risk-taking as they scan the financial horizon for signsof asset-price bubbles fueled by a benchmark interest rate that'sbeen near zero for more than five years.

Strong Inflows

High-yield corporate-bond and leveraged-loan funds “have seenstrong inflows, reflecting greater investor appetite for riskycorporate credits, while underwriting standards have deteriorated,raising the possibility of large losses going forward,” DanielTarullo, the Fed governor in charge of bank supervision, said in aspeech in Arlington, Virginia, on Feb. 25.

Inflows into U.S. mutual funds that invest in bank loans swelledto a record $61.3 billion last year, from $11.2 billion in 2012,according to data from Morningstar Inc. The debt has seenunprecedented demand because, in addition to yielding more thansafer securities, floating rates offer a shield from risingborrowing costs.

Investors have been “very sanguine regarding certain types ofexposure and modest in their demands for compensation to assumesuch risk,” Tarullo said.

Demand has allowed U.S. speculative-grade companies to lowertheir borrowing costs. The average yield on new loans in 2013 was5.2 percent, down from 8.5 percent in 2009, according to S&PCapital IQ Leveraged Commentary and Data.

When regulators conducted their annual review of bank creditlast year, they found the March guidance had gone unheeded. Of $429billion of leveraged loans they sampled, 42 percent were“criticized,” or classified as having a deficiency that might leadto a loss.

They then followed up with letters to individual banks startingin September.

“It is a bit too soon to judge precisely how effective”supervisory actions such as last year's leveraged-lending guidancehave been, Tarullo said in his speech last month.

Fed and OCC regulators have been meeting with bankers during thepast several weeks to discuss their responses to the letters,according to five people who participated in the meetings.

Competition Abounds

One obstacle regulators face: As they succeed in deterring firmsfrom some risky deals, competitors snap them up.

JPMorgan, for example, didn't arrange a refinancing this monthof a portion of Freescale Semiconductor Inc.'s more than $5 billionof debt—even though the New York-based bank helped put togetherearlier facilities, according to three people familiar with thedeal and regulatory filings. The Austin, Texas-based chipmaker islevered 6.8 times, according to high-yield research firm KDPInvestment Advisors Inc.

JPMorgan's abstinence hasn't stopped the deal from getting done.Citigroup, Barclays, Credit Suisse, Deutsche Bank, Goldman Sachs,and Morgan Stanley arranged the deal, according to data compiled byBloomberg. Tasha Pelio, a JPMorgan spokeswoman, declined tocomment. Kendrid Rodriguez, a Freescale spokeswoman, didn't respondto requests for comment.

Citigroup's decision to stand back from a debt package thatincluded a $735 million covenant-light term loan for KKR's buyoutof Brickman Group Ltd. didn't stop the landscaping company's dealeither, two people familiar with knowledge of the matter said.Kristi Huller, a KKR spokeswoman, declined to comment.

Brickman's B2 rating—five levels below investment-grade—reflectsthe company's debt-to-Ebitda of 6.8 times, “low profitability andweak interest-coverage metrics, relatively small revenue size, andlimited business diversity,” Moody's said in a Dec. 3 report.Morgan Stanley, Credit Suisse, and Goldman Sachs are among thebanks that helped arrange Brickman's loan.

Rob Julavits, a spokesman for Citigroup, and LaNellaHooper-Williams, a spokeswoman for Brickman, declined tocomment.

One challenge banks face as they seek to comply with regulators'guidance is its sweeping nature, said Beth MacLean, an executivevice president and bank-loan investment manager at Newport Beach,California-based Pacific Investment Management Co., which oversees$1.9 trillion in assets, including $15 billion of loans.

The maximum debt-to-cash-flow ratio “doesn't distinguish betweenan industrial company that should maybe have four times leverageand a media company that historically has been able to support sixto eight times leverage,” MacLean said.

Deficient Loan

Banks also have varying internal definitions of what constitutesa deficient loan. Underwriters determine themselves whether theloan is considered criticized at inception. Then, during an annualreview of bank credit, supervisors examine a sample of those dealsand assign their own ratings.

Regulators are concerned the amount of debt companies are pilingon exceeds their ability to repay it. Low-rated companies canborrow even after indicating they “will have to be reorganized, orare in bad shape,” the Fed's Fisher said.

Sedgwick, the Memphis-based claims processor in which KKR boughta majority stake, has “substantial” leverage of about eight timesEbitda after taking out covenant-light loans to fund the purchase,Moody's said in a Feb. 10 report. Banks marketed the deal with 7.1times leverage based on “adjusted Ebitda,” according to a dealdocument obtained by Bloomberg News.

Catherine Bennett, a spokeswoman for Sedgwick, didn't respond toe-mails seeking comment. Megan Stinson, a UBS spokeswoman, andMayura Hooper, a Deutsche Bank spokeswoman, both declined tocomment.

Applied Systems is also saddled with debt of about nine timesEbitda after taking out its covenant-light term loan led by CreditSuisse to finance the insurance-management software maker'spurchase by private-equity firms Hellman & Friedman LLC and JMIEquity, according to Bloomberg data and a Jan. 10 Moody'sreport.

“The leverage burden leaves Applied Systems virtually no roomfor operational error to respond effectively to competitivepressures or changing market conditions,” the Moody's report said.The University Park, Illinois-based company is rated B3, six levelsabove default.

Matt Fogt, a spokesman for Applied Systems, didn't respond torequests for comment. Drew Benson, a Credit Suisse spokesman,declined to comment.

Leon Black, founder of private-equity firm Apollo GlobalManagement LLC, said regulators' proposals to clamp down on debtlevels in leveraged buyouts are micromanaging.

'Blanket' View

“To have a blanket number like that is micromanaging too muchfrom a regulatory point of view,” Black said Feb. 28 at aconference in New York. “Different industries have different growthrates.”

Tighter credit could curb profits for private-equity firms likeApollo, if they are forced to put up more cash for their takeoversor are restricted from piling additional debt onto their portfoliocompanies for purposes such as paying themselves dividends.

The Fed, OCC, and the FDIC soon will undertake their annualreview of bank credit, which is usually conducted in May and June,according to the Fed's website.

Martin Pfinsgraff, senior deputy comptroller for large banksupervision at the OCC, said in a November interview thatregulators have a “whole array” of tools available if banks ignoretheir directives, including cease-and-desist orders and loweringthe supervisory scores that regulators give to banks. A lowerrating can affect a bank's flexibility to buy back stock, paydividends, engage in mergers, and expand branches.

Tarullo, in his speech last month, said central bankers mustpreserve the option of using interest rates to lean againstdangerous financial bubbles. They may have to do that, said Cato'sCalabria.

“It's all well and good for the regulators to say 'You need tobe aware of this risk,'” he said. “You also have to be aware thatinterest-rate environments create such strong incentives to do somethings.”

“I'm a believer you have to do this monetary wise.”

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.