Returns diminish in challenging year for pension funds worldwide

Greater need for transparency and stability in investing as returns diminish ..... Aivars Lode

Lackluster returns the norm in eventful year

In a year of exciting macroeconomic and market situations — with unprecedented monetary policy, the return of volatility, and the bottoming out of the commodities supercycle — one would be forgiven for expecting great things from pension fund investment returns in 2015.

But interesting happenings in the macro environment failed to translate into strong investment returns of pension funds in six of the world's major markets. 

The average pension fund in each of Australia, Canada, Japan, the Netherlands, the U.K. and the U.S. all produced investment returns lower than in 2014.  Canada and Australia were the standout markets for the year, helped along by falling currencies. 

The average Canadian pension fund returned 6% before taking inflation into consideration, said Bruce B. Curwood, director, investment strategy at Russell Investments Canada, Toronto. Last year was a “poor year for Canada,” he said. In 2014, Canadian pension funds returned on average 10.1% before inflation was taken into account. 

Mr. Curwood highlighted slowing growth in China and “the ineffectiveness of the OPEC oil cartel” leading to falling material and energy prices across the globe. These issues led to subdued domestic growth in Canada and low inflation, which Mr. Curwood said was hovering around 1.5%. 

As well as macro issues, Canada's major stock index, the S&P/TSX, was one of the worst performing stock markets in the developed world last year, returning -8.32%, he said. Interest rates also fell in Canada, increasing pension liabilities. He said five-year government bonds fell by 58 basis points, while 10-year yields dropped by 38 basis points and 30-year government bonds slipped 18 basis points in 2015. 

“Based on these three events, one would have expected extremely weak Canadian pension fund outcomes. However ... the silver lining for many domestic pension funds was the falling Canadian dollar and the extent of their global diversification strategy,” Mr. Curwood said. The Canadian dollar fell 16% vs. the U.S. dollar in 2015. “In short, any unhedged international investments resulted in a rebound to performance.”

Diversification pays 

Canadian pension funds' diversification strategies saw them move further away from the typical 60/40 portfolio, he added, investing more in alternatives, and in particular global infrastructure and global real estate. “In addition, many funds concentrated on better matching their investments (to their liabilities), while others utilized downside protection strategies, such as defensive equity,” said Mr. Curwood. 

Australian pension funds also benefited from currency depreciation. With the Australian dollar falling 10.9% vs. the U.S. dollar in the calendar year, investment returns were boosted to an average 5.6% before inflation, said researcher SuperRatings Pty. Ltd. That compared with returns of 8.1% in 2014. 

The key driver of Australian retirement fund returns in 2015 was international shares, with the median international shares investment option increasing 8.8%. In comparison, the ASX200 Accumulation index grew 2.6%. 

“We have noted in recent years many funds moving greater portions of their assets into international shares” and away from the domestic stock market, said Adam Gee, Sydney-based CEO at SuperRatings. The firm also has seen many not-for-profit pension funds gaining greater exposure to unlisted assets, such as infrastructure, private equity and hedge funds, he said. 

It was not just pension funds that failed to impress in 2015. The Russell 3000 index gained 0.48% over the year, vs. 12.53% in 2014; while the MSCI All-Country World index lost 1.79% in 2015, vs. a 5.62% gain the year previous. Bond markets also fared poorly, with the Barclays Capital U.S. Aggregate Bond index gaining 0.55% vs. 5.97% in 2014. 

These elements hit U.S. pension funds hard. Preliminary analysis of the 219 portfolios in Bank of New York Mellon (BK) Corp. (BK)'s universe shows an average investment return of -0.08%. John Houser, senior consultant for BNY Mellon's global risk solutions group, in Boston, said the last time the universe posted negative results to close the year was 2008, “when the universe median finished down with a -25.23% return.” 

The U.S. equity segment of its analysis produced a median result of 0.14% — that “significantly underperformed its historic average,” said Mr. Houser, with third-quarter median losses of 7.44% proving to be too much. The U.S. fixed-income segment median was -0.03%. 

“The real estate segment continues to be the asset class of choice as its median one-year return closed at 12.68%,” he said. 

For the average U.K. pension fund, which returned between 0% and 2% in 2015, “many will look back on 2015 as, I think, a bit of a damp squib,” said Phil Edwards, Bristol, England-based principal at MercerLtd. The year in the U.K. looks particularly weak compared with 2014's average investment return of 11% before inflation. 

These pension funds have continued to derisk, he said, with asset allocation analysis likely to reveal a reduced reliance on equities. “And also schemes are looking to add dynamism to portfolios,” using multiasset credit strategies that allow managers to shift across asset classes as the environment and opportunities change. 

Japan's pension funds also produced single-digit returns, with Russell Investments' universe of corporate pension funds in Japan returning on average less than 2%. 

“In the public pension area, the topic in 2015 which had the biggest impact was the allocation change of public pensions,” said Konosuke Kita, director of consulting at Russell Investments in Tokyo. He highlighted the $1.2 trillion Government Pension Investment Fund, Tokyo, which increased its equity allocation to 50% from 24%, and others that have followed this move. 

Corporate governance, he said, was another hot topic, following the publication of the Corporate Governance Code in 2015. “It will create pressure for investment managers to be conscious of corporate governance more than ever,” he said.

Fallen angel 

The biggest year-over-year fall in returns came from pension funds in the Netherlands, which produced an average investment return of 1.1% before inflation. That compared with a 15.8% return in 2014. 

Edward Krijgsman, Amstelveen-based principal and investment consultant at Mercer, said one reason for this “modest” return was an increase in interest rates. The 30-year swap rate in the eurozone increased to 1.61%, from 1.46%. The average Dutch pension fund has hedged about 40% of the interest rate risk of nominal liabilities. 

Mr. Krijgsman added that Dutch pension funds benefited from falling allocations to hedge funds and commodities. “The ambition of Dutch pension funds to invest more in hedge funds has reduced the last three years, driven by increased transparency (demands) from De Nederlandsche Bank, plus poor performance. It is the same for commodities, although transparency requirements are a bit less for them.” 

The HFRI Fund Weighted Composite index returned -1.02% in 2015; and the Bloomberg Commodity index returned -24.66%. 

Dutch pension funds also benefited from another year of euro depreciation vs. the dollar, with a 10.22% drop in 2015. Mr. Krijgsman said Dutch pension funds on average hedge 50% of their currency risk. 

Alongside lower investment returns were lower funded ratios, falling to 104% from 108% in 2014. 

However, Dennis van Ek, principal and investment consultant also at Mercer in Amstelveen, said the average funded ratio actually would be 110% were it not for a change in Dutch pension fund rules last year under the Financial Assessment Framework, known as the FTK. 

De Nederlandsche Bank, the Dutch financial regulator, dropped the ultimate forward rate — the discount rate used to calculate liabilities — to 3.3% from 4.2%, in 2015. “Because of that, and other changes, the funded ratio fell to 104%,” Mr. Van Ek said, with the change leading to an increase in liabilities. The change means many pension funds in the Netherlands are dealing with having to recalculate their recovery plans. 

By Sophie Baker - Pensions & Investments

Private Equity's Golden Age Wasn't So Golden After All

Interesting stats in here on how the golden age of private equity was not...Aivars Lode

Henry Kravis called it private equity’s golden age. From 2005 to 2007, buyout firms paid fat prices to buy about 20 supersized companies, from Hilton Worldwide Holdings Inc. to Hertz Global Holdings Inc.

Now, a decade later, the results of that debt-fueled spree can be tabulated -- and it’s hardly golden. The mega-deals produced mostly mediocre returns, falling well short of the profits that leveraged buyout shops typically seek, according to separate compilations by Bloomberg and asset manager Hamilton Lane Advisors. In more than half the deals -- each valued at more than $10 billion -- the firms would have been better off if they had put their investors’ money into a stock index fund.

Henry Kravis

 

Photographer: Daniel Acker/Bloomberg

Have the Masters of the Universe learned a lesson? They say they have. Caution is now a watchword and less is more. TPG Capital has sworn off buyouts as large as $30 billion, people with knowledge of its thinking said, while other shops will consider enormous deals only if the price is right. But so far none has led a $10 billion or bigger transaction since the financial crisis.

Read full article here

Fondo Priamo tenders Italian private debt mandate in alternatives push

Another Pension fund allocating to private debt.  Aivars Lode

Fondo Priamo, Italy’s second-pillar pension fund for public transport sector employees, is tendering an Italian private debt mandate.

Priamo, which managed €1.2bn at the end of last year, intends to implement the allocation to private debt through a fund-of-funds structure.

The size of the mandate will be €15m, around 1.2% of total assets.

Managers have until 3 February to provide the required documentation. 

Throughout the manager search, Priamo is being assisted by Link Institutional Advisory, a consultant based in Lugano, Switzerland.

If the allocation is successful, the fund will be among the first second-pillar trade union-backed pension funds in Italy to invest in private debt.

Osvaldo Marinig, chairman at Priamo, told IPE the fund-of-fund structure was chosen to ensure appropriate diversification.

He said implementing the allocation through a fund-of-funds structure would be a challenge, given the lack of similar investment by Italian schemes.

The project will require intense dialogue with the pension regulator, COVIP, Marinig added.

The fund is planning to add private debt to its evolving alternative assets portfolio, following a review of the strategic asset allocation that took place at the end of 2015.

As part of the review, Priamo increased the strategic allocation target for alternatives from 5% to 7%.

Marinig said the fund was evaluating other asset classes for the rest of the alternatives portfolio.

Marinig explained that private debt was preferred to real estate, for reasons including the timing of the investment.

The fund had foreseen an allocation to real estate around two years ago but never implemented the strategy.

But Maring said the time to invest in real estate was now less than ideal.

Other incentives for the investment were the potential risk-adjusted returns and cashflow profile of investments.

During 2015, the fund moved from a benchmark approach to an absolute return one.

Among the reasons for this change were fluctuating membership figures.

Marinig noted the fund was maturing more quickly than others, with the members’ age profile getting older.

However, 2016 will see a review of collective public transport sector agreements, and a wave of redundancies is expected.

At the same time, Marinig expects the fund will receive a significant influx of members, as the sector’s trade unions agree to a form of automatic enrolment as part of the new contractual agreements.

The model – whereby employees are automatically enrolled in the fund with a minimum employer contribution but no obligation to contribute themselves – has already been adopted by Prevedi, Italy’s construction sector scheme.  As a result of the likely introduction of automatic enrolment at Priamo, Marinig foresees that membership could double, although assets will grow much more slowly.

BY CARLO SVALUTO MOREOLO

Investment and Pensions Europe

Why debt managers love volatility

Why debt managers love volatility and why execution is important....
Aivars Lode

It’s not yet clear if the leveraged finance market will continue to stutter or if it’s just taking time for bank lenders and high-yield investors to return to business as usual. In the meantime, private debt managers are making hay.  

The high-yield bond and syndicated loan markets have had private debt managers transfixed lately, with all eyes in particular on Symantec’s sale of data storage business Veritas to The Carlyle Group and GIC.

Agreed in August 2015, the deal’s original $3.3 billion loan and $2.28 billion bond package took months to come together, and was shunned by both the high-yield and leveraged loan markets even when the underwriters reportedly took measures to sweeten the deal for investors. The latest twist came this week, when the sale price was cut from $8 billion to $7.4 billion, allowing the debt financing underwriters to reduce the deal’s debt package by $1.2 billion. 

This isn’t the only private equity deal struggling to syndicate its financing. Last week, it emerged that KKR’s private equity arm had struggled to find lenders to back its $1.2 billion acquisition of Mill Fleet Farm, a US regional retail chain. After shopping the deal with around 20 banks, KKR reportedly sold the debt financing down to pension funds and asset managers itself, according to Reuters.

The reason this deal and, more broadly, the high-yield bond and syndicated loan markets are holding the attention of debt managers is that a stuttering liquid leveraged finance market means a positive trickle down for more flexible private credit providers. 

The wobbles in the US large-cap leveraged finance market started last year and have continued into the first three weeks of 2016. One mid-market private lender estimated that pricing has increased around 100bps since the summer on the back of syndicated loan and high-yield bond market wobbles. 

In Europe, in the last quarter of 2015, lenders were forced to reduce the leverage on Global Blue’s €572 million loan from 4.5x to 3.7x. Since the market reopened in January high-yield bond prices have fallen. On the leveraged loan market, deals have launched this year but one advisory source says everyone is waiting to see how syndications go for the first transactions. One such is the £620 million-equivalent ($890 million; €822 million) of sterling and euro debt backing TDR Capital’s £1.3 billion acquisition of fuel retailer Euro Garages which was launched in the first week of January. 

Substantial falls in equity markets and wider macro disquiet have had an impact on the more liquid elements of the leveraged finance markets that the bulk of private debt managers focus on. Those same managers aren’t just hanging around waiting to see how it all pans out, of course. Funds are actively pitching for business that in a stronger credit market would go elsewhere, says the advisory source. 

Their pitch of flexibility, long-term match funding and most importantly, certainty of execution, is brought most sharply into relief when there is less confidence in other credit markets. 

Thus, in contrast to the rest of the investment community, debt managers are, for the medium-term at least, hoping that the very volatility drawing attention among the business titans gathered this week in Davos doesn’t halt too quickly. 

Private Debt Investor 

Buy-and-maintain credit strategy demand growing

Investors continue to look for risk adjusted returns...

Most clients coming from U.K., but global interest is on the rise
Global money managers are seeing constant — and in some cases increased — demand for buy-and-maintain credit strategies from across the globe, as lower liquidity, cost concerns and the flaws in both active and passive credit management creep higher up the agenda of institutional investors.

Executives at money management firms said while U.K. clients have largely been the lifeblood of buy-and-maintain strategies, the U.S. is becoming a new hunting ground for allocations to these benchmark-agnostic, low-turnover, investment-grade credit strategies. 

“Interest is accelerating,” said Simon Males, head of global fixed-income distribution at Legal & General Investment Management in London. “We have a number of new buy-and-maintain investors from the euro region as well as U.S. dollar region - there is definite interest and execution.” 

Mr. Males declined to name clients. LGIM runs £54.3 billion in buy-and-maintain strategies. 

Andy Burgess, London-based fixed-income product specialist at Insight Investment, said the money manager has seen client inflows into segregated allocations principally from the U.K., although buy-and-maintain is becoming more popular in the U.S. and Asia. Insight also is seeing more popularity for its pooled buy-and-maintain strategy, which it launched in June 2013, and now has more than £1 billion ($1.5 billion) in assets. Overall, Insight has £17.2 billion in buy-and-maintain strategies. 

Most commonly found as an alternative to actively or passively managed investment-grade credit portfolios, buy-and-maintain has benefited from the drawbacks of both these types of management strategies. Sources highlighted issues with forced selling in the case of passive investment, and the higher management fees associated with active management. They said investors can expect a five basis points to 10 basis points fee reduction vs. active management — about a 25% to 33% discount. 

“We are not doing buy-and-maintain in fixed income, but I think it's interesting,” said an executive at a U.K. pension fund who requested anonymity. “It overcomes the liquidity issues in credit and, by buying less liquid or unusual bonds, some additional yield can be harvested. (That is) something we (as long-term investors) should get around to doing something about.” 

Sources at money management firms said a typical buy-and-maintain portfolio will have turnover of about 10% per year. One source said his firm's active funds typically have up to 40% turnover per year, down from about 80% a few years ago when liquidity was less of a concern. He said even 40% is low turnover for an active strategy.

Recent moves 

A number of high-profile U.K.-based pension funds recently have made the move to buy-and-maintain credit strategies: 

nRPMI RailPen, the in-house manager for the £21 billion Railways Pension Scheme, London, moved its £625 million investment-grade bond portfolio to a buy-and-maintain credit strategy in November. Craig Heron, investment manager at RPMI RailPen, said in an interview at the time that executives want to hold a straightforward portfolio, do not want to be forced to sell or trade bonds — except in the case of significant downgrades of holdings — and expect to save 50 to 60 basis points by removing trading costs associated with the portfolio. 

nSouth Yorkshire Pension Fund, Barnsley, England, appointed Royal London Asset Management to run a £250 million buy-and-maintain credit strategy, it announced in a filing in May. Executives at the £6.3 billion pension fund could not be reached for comment. 

nEnvironment Agency Pension Fund, London, said in its latest annual report for the year ended March 31 that part of its bond allocation “has been refocused on a "buy-and-maintain' basis, giving us a low-cost portfolio with a better balance and more consideration of environmental, social and governance issues than an indexed allocation would achieve.” Executives at the £2.7 billion pension fund could not be reached for comment.

Overcoming strategy flaws 

“Reflecting education and support with the consulting market, there has been significant increase in demand for buy-and-maintain credit, with (U.K.) investors typically looking to transition from passive mandates of sterling credit, to one or a combination of buy-and-maintain and multistrategy credit,” said Mr. Males. 

Insight's Mr. Burgess said buy-and-maintain “has been popular for a while, but it is certainly getting more prominent now, and people are waking up to the flaws in passive investment.” 

There are a number of problems with tracking a bond index, said sources. “There has always been criticism about fixed-income benchmarks, and active management can mitigate some of the inherent risks and biases,” said David Rae, London-based head of client strategy and research, and head of liability investment solutions at Russell Investments. “Buy-and-maintain is an extension of that, to take a cheaper approach.” 

Risks for passive strategies include concentration. “A U.K. credit benchmark has about a 35% weighting to financials, and a relatively small number of companies makes up a large proportion of the index; by moving away from the benchmark you can create a portfolio which is better diversified, and you should expect better risk-adjusted returns over a market cycle,” said Joe Abrams, a researcher in consultant Mercer Ltd.'s fixed-income division, based in London. He said the firm has been encouraging clients to move toward buy-and-maintain credit for some time, and away from benchmark-relative active or passive strategies. 

In avoiding benchmarks, buy-and-maintain “takes off that straitjacket,” said Shalin Shah, London-based credit fund manager at Royal London Asset Management. The strategy can also avoid forced selling, with portfolio managers able to make decisions on whether to hold onto a “fallen angel” bond that has been downgraded to subinvestment grade, allowing buy-and-maintain managers to capture inefficiencies in credit markets, he said. 

The maturation of pension funds also has contributed to the popularity of buy-and-maintain. “Demand has come from a need to better match the liability portfolio in terms of duration, length of maturity of liabilities and cash flows,” said Mr. Shah. The majority of the £3 billion RLAM runs in buy-and-maintain invested assets or those under transition to buy-and-maintain are invested via segregated arrangements. But there is also demand for its pooled strategy, he said. 

Mr. Burgess said Insight also has seen inflows from clients who have been very happy with Insight's active management performance, “but don't need that alpha generation anymore.”

A different set of rules 

Despite reduced transaction costs, less concentration risk and a fee reduction vs. active strategies, Willis Towers Watson PLC is not convinced these elements are compelling enough to recommend the strategy to clients. 

“We do see the merit in the basic thesis of avoiding transaction costs, but that, plus a modest fee discount, is not enough to overwhelmingly” put the consultant in buy-and-maintain's camp, said Chris Redmond, global head of credit at Willis Towers Watson, based in London. He highlighted concerns over forced selling in some cases; that these strategies might be “orphaned or forgotten about;” and difficulty in measuring success. 

Managers and their clients therefore need to be smart about how they implement, run and monitor buy-and-maintain portfolios. 

“Buy-and-maintain strategies are actively managed but the active decisions are more front-loaded, despite the ability to actively "maintain' the portfolio. One of the obvious drawbacks is accountability - if there is no benchmark, it is difficult to attribute performance,” said Mr. Abrams. 

Therefore, a custom set of measurements are necessary for managers to demonstrate that they are adding value vs. other options, said sources. These might include comparing the default rates of holdings within a strategy against the broader credit market index, and tracking costs and turnover. 

By Pensions & Investments

Feds Win Fight Over Risky-Looking Loans

Why the world will move to debt funds that are specific to an industry...

Controversial push on leveraged loans extends regulators’ reach beyond banks and across entire financial system

Federal Reserve official Todd Vermilyea left no doubt about what regulators thought of a risky-looking type of loan made to companies when he spoke at a banking conference last year. “No, no, no, no, no,” said Mr. Vermilyea, a senior associate director at the Fed.

What happened after that shows how relentless pressure from regulators is forcing banks to do business differently in the wake of the financial crisis.

Leveraged loans, which go to companies already deep in debt, fell about 20% in dollar volume through October from the same period last year. And underwriting standards on those loans have improved in the past year, according to a recent report by three federal banking agencies.

“We learned a lesson” from the financial crisis, says one former regulator who pushed for a crackdown when leveraged loans surged in 2013 and standards slipped. “You can’t wait.”

Regulators and banks have clashed repeatedly over how to best shield the financial system from the next crisis. The leveraged loan battle has been one of the thorniest because regulators extended their reach beyond individual banks and across the entire financial system.

Banks also objected because their primary role in leveraged loans is as middlemen who arrange a loan and sell it in pieces to outside investors. The banks bear less risk if the borrower defaults than if they held on to the loans.

Hefty profits

Leveraged loans generate hefty profits for banks such as Credit Suisse Group AG and J.P. Morgan Chase & Co. Borrowers include Wendy’s International Inc., SeaWorld Entertainment Inc. and PetSmart Inc.

While leveraged loans didn’t cause the financial crisis, their postcrisis boom alarmed regulators who saw an eerie parallel to the mortgage bonds that battered investors world-wide during the foreclosure epidemic.

“Our banks are completely tied to the broader financial system in some form or fashion, so if there is weakness in one part of the system, it is likely going to have negative consequences for the banks,” says Darrin Benhart, the Office of the Comptroller of the Currency’s deputy comptroller for supervision risk management.

In response, the Fed, OCC and Federal Deposit Insurance Corp. strong-armed U.S. banks for the first time ever to comply with minimum underwriting standards on leveraged loans no matter who shoulders the credit risk.

The heightened scrutiny has included monthly reviews of individual banks’ leveraged loan portfolios. Regulators also have lowered the boom on some lenders in so-called private letters, for which failure to comply can lead to fines or curbs on lending, dividends and other activities.

Last year, the U.S. units of Switzerland’s Credit Suisse and Germany’s Deutsche Bank AG got letters demanding “immediate attention” to their leveraged loan portfolios, people familiar with the matter say. The banks declined to comment.

Many bankers say the government is overreacting and could make it harder for companies to borrow when they need to. “The unintended consequence may be that this restricts access to credit in a downturn,” says Chuck McMullan, a senior managing director of investment bank Evercore Partners Inc. ’s debt advisory group.

The crackdown also has encouraged companies to take their leveraged loan business to firms that aren’t regulated by the Fed and OCC, such as Leucadia National Corp. ’s Jefferies Group LLC and Nomura Holdings Inc. of Japan.

In the second quarter, financial firms that aren’t overseen by the Fed or OCC took the lead role in arranging 8% of all leveraged loans by volume, up from 3.8% a year earlier, according to S&P Capital IQ LCD, part of McGraw Hill Financial Inc. Regulators say the shift needs to be monitored but doesn’t seem to pose a threat to financial stability.

Still, the consensus among even government officials is uneasy. Jerome Powell, a Fed governor who helps set regulatory policy and previously was a partner at private-equity firm Carlyle GroupLP, said in a February speech that regulators were justified in their actions but should be careful about interfering with willing buyers and sellers in the capital markets.

”Financial stability need not seek to eliminate all risks,” Mr. Powell said. “We need to learn, but not overlearn, the lessons of the crisis.”

As of Oct. 31, leveraged loan volume totaled $382.3 billion so far this year, down 21% from the same period in 2014, according to S&P Capital IQ LCD. Loans to fund leveraged buyouts, in which a small group of investors uses borrowed money to purchase a company, fell 11% to $67.7 billion.

Government red tape isn’t the only reason for those declines. The recent collapse in commodities prices led some banks to reduce their exposure to energy companies, which tend to be major leveraged loan borrowers.

Some private-equity firms are doing fewer takeovers with loans because the stock prices of potential targets are too high. Meanwhile, demand from some loan investors has slackened.

In some ways, the reining in of leveraged loans goes all the way back to 2006, when the Fed, OCC, and FDIC cautioned that they had noticed “increasing credit risk” in a rapidly growing part of bank loan portfolios.

Companies were borrowing more relative to their earnings. Private-equity firms used more debt to finance corporate takeovers. Banks backed deals that included fewer protections for lenders if the borrower’s finances deteriorated.

Lenders largely ignored the warning. According to S&P Capital IQ LCD, leveraged loan volume reached a then-record $534.8 billion in 2007 as banks bundled the loans into securities and sold them to investors.

“As long as the music is playing, you’ve got to get up and dance,” Charles Prince, then chief executive of Citigroup Inc., told the Financial Times in a reference to the market for corporate buyouts by private-equity firms. Those takeovers poured fuel on the leveraged loan business.

But demand dried up when the financial crisis erupted. Citigroup suffered losses of $5 billion on its leveraged loan portfolio from mid-2007 to mid-2008. Across the industry, large lenders got stuck with more than $300 billion of leveraged loans and commitments they couldn’t sell.

Regulators disagreed

By 2012, though, leveraged loans were bouncing back. Low interest rates and profit-hungry investors pushed total loan volume to $465.5 billion.

U.S. Bancorp’s Richard Davis said regulators started ‘auditing hard’ after the government announced tougher scrutiny of leveraged loans. Photo: Jerry Holt/Minneapolis Star Tribune/Zuma Press 

Some veteran regulators, including at the Fed, wanted to issue general guidelines and leave lending decisions up to the market, say people who participated in the discussions. If banks were selling the loans to willing investors, these regulators thought, then federal agencies shouldn’t intervene.

Other regulators were adamant about the need for a single, specific underwriting standard for all loans. They recalled how the Fed, OCC, and FDIC had published joint guidelines for risky mortgages in 2006 and 2007, but that was too late to ameliorate or avert the housing crash.

Single-standard proponents included members of the OCC’s influential National Risk Committee. The Fed’s new head of banking supervision and regulation, Michael Gibson, also endorsed the approach, and it prevailed.

New lending guidelines issued in March 2013 directed banks to follow the same underwriting standards regardless of whether they were holding loans or selling them. The guidelines detailed how banks should identify risky loans, evaluate a borrower’s ability to repay and make sure the bank had adequate protections in place in case of default.

Regulators were explicit about loan characteristics that would grab their attention, such as lax repayment time lines and the absence of loan covenants. Any loan that left a company with debt exceeding six times its earnings before interest, taxes, depreciation and amortization, known as Ebitda, “raises concerns for most industries,” regulators wrote in the guidelines.

Lenders seemed to shrug—and kept on making leveraged loans. Volume set a record high in 2013, surging to $607.1 billion. Nearly one in three large, corporate LBOs failed the Ebitda test specified by regulators, according to S&P Capital IQ LCD.

Starting in late summer, roughly a dozen big banks received a “Matters Requiring Attention” letter from the OCC and the Fed. The letters chided the banks for putting the financial system at risk because of lax and inadequate application of the leveraged loan guidelines, regulators claimed.

Regulators “came and started auditing for it—and I mean auditing hard, every one of us,” U.S. Bancorp Chairman, President and Chief Executive Richard Davis said at a conference in November 2013. The Minneapolis bank isn’t a major participant in the leveraged loan market and didn’t get a letter.

Some banks buckled to the pressure but complained that rivals kept doing business as usual. 

Holdouts often claimed that many of their loan deals were made before the regulatory warning, while other lenders said the guidelines weren’t clear or were being interpreted differently by the Fed and OCC.

At the OCC, the task of bringing banks in line fell to Martin Pfinsgraff, who worked on leveraged loans while an executive at Prudential Financial Inc. and came to the OCC after the financial crisis. Mr. Pfinsgraff, senior deputy comptroller for large bank supervision, favored a “no exceptions” approach, meaning banks should never make a leveraged loan that fell outside the standards.

But Fed officials told lenders that they were willing to agree to disagree on individual loans, as long as banks judged deals in a way that met the Fed’s expectations. Some bankers saw that as granting them a handful of free passes.

In January 2014, Carlyle announced a $4.15 billion buyout of Johnson & Johnson ’s blood-testing unit, one of the largest deals that year. Bank of America Corp. and J.P. Morgan, both overseen by the OCC, sat out the deal.

Barclays PLC, Goldman Sachs Group Inc. and UBS Group AG, all supervised by the Fed, were among the lenders that funded the buyout. They declined to comment. Carlyle also declined to comment.

Senior officials at the Fed became convinced that they needed to speak out, partly to clarify the perception of a discrepancy between the two agencies. Fed Chairwoman Janet Yellen directed officials to step up their enforcement of the guidelines, and they sent Mr. Vermilyea to the conference in Charlotte, N.C., to deliver his warning.

In July 2014, Ms. Yellen called out “pockets of increased risk-taking across the financial system,” including leveraged loans. In a speech, she said the loans didn’t pose a “systemic threat” but added that the Fed was ready to act.

The warning letters to banks made it clear that regulators weren’t about to back down. Less than a day after The Wall Street Journal reported that Credit Suisse got a letter, the bank pulled out of deals, including private-equity firm Hellman & Friedman’s acquisition of Grocery Outlet Inc. 

Until that point last year, Credit Suisse had arranged or sold about $53.8 billion of leveraged loans marketed to U.S. investors in 2014, giving the Swiss bank a market share of 6.5% and about $702 million in fees, Dealogic estimated. Credit Suisse declined to comment.

In late 2014, Mr. Pfinsgraff and Timothy Clark, a senior associate director in the Fed’s bank oversight division, met with chief risk officers of Wall Street financial firms at the Pierre Hotel in New York City to make sure the message was loud and clear.

“We got read the riot act,” says one banker who was there. “You’ve got to change behavior.”

At the recent pace, leveraged loan volume this year would shrink to $459 billion in 2015, the lowest total since 2011, according to S&P Capital IQ LCD.

In a report last month, the Fed, OCC and FDIC said banks “are making progress,” though many leveraged loans still raise concerns about the borrowers’ ability to repay. 

The regulators have begun to worry about something else: loans to energy companies that might be in trouble because of volatile fuel prices.

By Ryan Tracy - WSJ