By Lynn Adler and Kristen Haunss
NEW YORK (Reuters) - Big investment banks are facing their toughest test yet in the current 2015 Shared National Credit (SNC) review, months after regulators warned the banks that the quality of U.S. leveraged loans that they arranged was not as good as the banks claimed, sources said.
Regulators met with banks earlier this year after monthly monitoring started in 2014 revealed that several deals that banks claimed were in "good standing" were riskier than recorded, four people with knowledge of the discussions said.
Updated leveraged lending guidelines were introduced in March 2013 to curb risky lending that regulators deemed could pose a systemic threat if unchecked.
Regulators followed up and issued Matters Requiring Attention (MRA) letters to banks in the third quarter of 2013 and took an even tougher line and sent at least one Matters Requiring Immediate Attention (MRIA) notice. Credit Suisse received an MRIA in September 2014, sources said.
Although the regulators' discovery that the quality of loans that banks were arranging was not as good as they claimed did not prompt regulatory action other than requests to improve, it raised the stakes for this year's SNC review, which is currently under way.
The SNC review, which looks at the quality of bank loans, is now an annual exam with a single report, but starting next year there will be two exam periods with a single report. Banks identified in the SNC review that fail to meet regulators' standards may be fined or penalized, according to bankers and attorneys.
"The process of the SNC review and ultimately the report will be significant," Alan Avery, a partner in the corporate department at Latham & Watkins in New York, said in an interview. "Either there are more satisfactory approaches being taken or there are not, and either way it's going to be a big deal."
The guidelines, which took effect in May 2013, are designed to make the $840 billion U.S. leveraged loan market, which extends credit to non-investment grade rated companies, including pet retailer PetSmart Inc and discount retailer Dollar Tree Inc, safer.
Regulators found that certain lending characteristics were "aggressive" and flagged in the guidelines covenant-lite loans and debt compared to earnings before interest, tax, depreciation and amortization (EBITDA), or leverage, of more than 6.0 times. The guidelines also said loans should be able to pay back at least 50 percent of total debt within five to seven years.
The regulatory crackdown helped push leverage ratios to 5.99 times earnings in the first three months of 2015, the lowest level since the same quarter in 2013, according to Thomson Reuters LPC data.
"It is important and interesting that the regulators are using the SNC process as a vehicle to deliver a coordinated view on how the leveraged lending guidance has been implemented," Avery said. The regulators "have tied SNC with implementation, so it becomes increasingly important each year as a tool to best judge how things are being implemented."
The Federal Reserve (Fed), the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp (FDIC) conduct the SNC to scrutinize the credit quality of large loan commitments made by the banks.
"It's really this SNC review that's going to be the opportunity for the regulators to give effective and meaningful guidance to banks," J. Paul Forrester, a partner focused on corporate finance at Mayer Brown in Chicago, said in an interview.
Last year regulators put more emphasis on leveraged lending and released a supplement about implementation of the 2013 guidelines and answers to frequently asked questions after bankers complained about a lack of clarity and consistency.
Regulators said last year that banks continued to "originate a large volume of non-pass transactions at inception," and found that 31 percent of loans had weak underwriting structures, according to the leveraged lending supplement.
Bankers and lawyers say that guidance, rather than rules, still leaves some lending practices unclear.
"In 2013 the regulators gave us the new guidance that said 6.0 times leverage was really bad," Forrester said. "In 2014 they said 6.0 times was not necessarily a bright-line test but it's still pretty bad. If they really want to curb excessive leverage, I think they've got to be more granular and specific, and they can’t leave it as vague as the current guidance is."
Spokespeople for the Fed, OCC and FDIC declined to comment.
U.S. leveraged loan volume has fallen since the guidelines were issued, with $41 billion of institutional loans arranged in the United States in the first quarter, 77 percent lower than the same period of 2014, according to Thomson Reuters LPC data, and well below the pace that led to an annual record of $625.5 billion in 2013.
Average total leverage ratios on large corporate buyouts were 6.11 times when the guidance went into effect in 2013. Leverage continued to climb after the guidelines were issued, rising as high of 6.96 times in the third quarter of 2014, and then falling the next two quarters.
Debt levels have remained the same in the current quarter, with average leverage on large buyouts hitting 5.98 times as of June 23, according to the data. Total leverage remains well below the 7.1 times set in 2007, a 12-year peak based on LPC figures dating back to 2003, and below the 6.0 times regulatory hurdle that the guidelines said 'raises concerns.'
Large corporate loans with ratios of more than 7.0 times accounted for 6.7 percent of buyout deals announced in the current quarter, down from 12.5 percent in the first three months of the year and sharply lower than the 42 percent recorded in the second quarter of 2014, according to the data.
While leverage is falling, a perhaps unintended consequence of the regulatory pressure is that more debt is being arranged by lenders that are not overseen by the Fed, OCC or FDIC.
"The guidance is already having an impact," Brad Rogoff, a credit analyst at Barclays, said in an interview. "The average leverage for new LBOs has certainly come down and deals with high leverage are being done by non-regulated entities."
(Editing By Tessa Walsh and Michelle Sierra)