Leveraged-loan rules give banks an edge over brokers
When it comes to losses on leveraged loans – a big source of worry for investors in financial firms – banks may have an advantage over their brokerage-house rivals in weathering the storm.
Thanks to a quirk in accounting rules, banks such as JPMorgan Chase do not always have to book losses immediately on those loans, even as brokers such as Goldman Sachs Group are forced to take hits right away.
Leveraged loans – used by companies, usually with low credit ratings, and often to fund buyouts – were originally made with the idea that banks and brokers would quickly sell them to investors. When markets froze in August, institutions found themselves stuck with billions of these loans that they could not unload.
That led to losses last autumn as financial firms were forced in many cases to mark these loans down by about five per cent. The market for these loans is again struggling, and prices are falling further – in some cases to about, or even less than, 90 cents (Dh3.3) on the dollar – which will probably lead to another round of losses at financial firms.
This is not to say that banks will be able to entirely sidestep losses stemming from leveraged loans issued to fund huge corporate buyouts. But any kind of shock absorber would be welcome, given the depressed market conditions now.
Banks and brokers have nearly $200 billion in leveraged-loan exposure. Given recent falls in market prices of these loans, that could lead to $10bn to $14bn in write-downs, Oppenheimer analyst Meredith Whitney estimated in a recent note.
Among banks, Citigroup and JPMorgan have the most at stake, with $43bn and $26.4bn in exposures, respectively, as of the end of last year. Among brokers, Goldman has the biggest leveraged-loan exposure, at $26bn, followed by Lehman Brothers Holdings with $23.8bn.
The differing approaches also underscore that even as the use of so-called market values cause some firms to quickly recognise big losses – even if there are growing questions about the reliability of these values in frozen markets – not every financial player always has to measure up against this same yardstick.
JPMorgan said in January that it had reclassified about $5bn of $26bn in leveraged loans it holds. It declined to comment beyond what Chief Executive James Dimon said during a conference call.
That said, the more favourable accounting treatment does not hurt, either. Here is how it works: Companies either classify loans as being “held for sale” or as investments, sometimes referred to as “holding to maturity”. Loans held for sale are carried at whichever is lower: the original cost or the current market value.
But the value of loans held for investment does not change with every uptick or downtick in the market. Instead, such loans are said to be held at their cost, although they are initially marked to market prices if a firm is reclassifying them from held for sale.
The big benefit is that holding loans for investment reduces volatility. Brokers like Goldman, Lehman, Morgan Stanley or Merrill Lynch, on the other hand, have to mark just about everything they hold to market prices. So the firms – which together have about $91bn in leveraged-loan exposure – take losses right away.
This is not to say banks completely avoid losses on loans held for investment.
But in checking to see whether the value of a held-for-investment loan is impaired, a bank would look to see if there has been a change in the credit rating of an issuer, if the issuer has fallen behind in interest payments or if it looks like a delinquency could be looming.
$0.90: Or even less on the dollar is the price of leveraged loans as the market for these debts is again struggling while the prices are falling further
$200bn: Is the approximate amount of leveraged-loan exposure of banks and brokerage houses, which could lead to $10bn to $14bn in write-downs
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