By the Numbers

Banks’ surprising view of default risk in leveraged loans

Steven Abrahams | May 31, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Banks presumably know something about making loans and have good information about the willingness and ability of borrowers to repay. For syndicated loans, those opinions get reported in shorthand every quarter through the Shared National Credit Program, where banks and others pencil in a probability of default within two years for their biggest and most complex credits. Those probabilities have gone up in recent quarters but, at the end of 2023, still implied a surprisingly low 2.20% default rate. With 1.3% of banks’ syndicated loans already in default, banks’ forward view of risk paints a surprisingly benign picture.

A picture of syndicated loans through the Shared National Credit Program

US banks’ report their view of the default risk in syndicated loans through the Shared National Credit Program, The SNC monitors the biggest and most complex credits held by banks and other depositories, insurers, pension and mutual funds and other regulated institutions. Both drawn and undrawn syndicated lines of credit show up on the SNC radar as well as syndicated term loans. A loan can show up on the balance sheet of any reporter.

The term loans in the SNC include a lot of loans owned by CLOs, and the SNC makes clear that banks retain a sizable participation in the term loan market. Since mid-2015, the SNC figures show banks holding between 35% and 38% of the total. At the end of last year, banks held $586 billion and non-banks held $976 billion (Exhibit 1). The SNC total of $1.56 trillion is larger than the $1.40 trillion par balance of the Morningstar/LSTA leveraged loan index possibly because the index excludes second liens, loans with terms of less than one year, loans with an initial spread below index + 125 bp and loans with initial issue size less than $50 million.

Exhibit 1: Banks since mid-2015 have held 35% to 38% of syndicated term loans

Note: The SNC series only starts in 2009.
Source: Federal Reserve, Santander US Capital Markets

Reporting expected default risk

The Fed, the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency ask banks and non-banks every quarter to categorize their loan exposures by the probability of default over the following two years. Holders report results in 10 categories:

Missing (no estimate provided)
No risk
0% to 0.5%
5% to 1.0%
0% to 2.5%
5% to 5.0%
0% to 10%
10% to 25%
25% to 100%
Defaulted

Banks report fewer missing estimates and have a longer track record of reporting loan risk to regulators, so that is the focus here.

SNC default history tracks the Morningstar/LSTA leveraged loan index

Comparing banks’ reported rates of term loan defaults to defaults in the Morningstar/LSTA leveraged loan index suggests banks are dealing with comparable risk. The SNC and the index report defaults in slightly different terms. The bank numbers reflect loans in default at the end of each quarter while the index reports cumulative loans in default in the prior 12 months; bank rates consequently should be lower. Both bank and index numbers show high default rates toward the end of the Global Financial Crisis, a sharp drop afterwards and rates below 2% since (Exhibit 2). The index shows higher rates after Energy Future Holdings, formerly known as TXU, went bankrupt in 2014 and after the start of pandemic in 2020. Otherwise, the bank and index default rates are roughly aligned.

Exhibit 2: Banks reported term loan defaults align roughly with index levels

Source: Federal Reserve, Pitchbook LCD, Santander US Capital Markets

Banks forward-looking view of risk

Arguably the most valuable part of the SNC is the forward-looking view of default risk, and that shows rising but still relatively low estimates of expected default. That is true whether the picture includes loans with missing default estimates (Exhibit 3A) or excludes those loans (Exhibit 3B). The easiest way to see banks’ changing views is to focus on the category of loans reported as having no risk. That category ran above 10% of total bank loans—including loans with missing estimates—from the end of 2021 through September 2022. It has since dropped to 1.4% at the end of 2023. Of course, the share of loans with some risk has gone from less than 90% to 98.6%.

Exhibit 3A: SNC bank estimates of loan default risk (including missing estimates)

Exhibit 3B: SNC bank estimates of loan default risk (excluding missing estimates)

Source: Federal Reserve, Santander US Capital Markets

Despite banks’ rising estimates of default risk, expectations still look low. Taking the par balance of loans as of December 2023 with available default estimates and weighing them by the midpoint of their probability-of-loss category, banks in aggregate expect $8.15 billion of defaults on $370.3 billion in reported loans, or a default rate of 2.20% (Exhibit 4). That is a relatively low rate—far lower than defaults during the GFC.

Exhibit 4: Implied default rate in SNC bank estimates

Source: Federal Reserve, Santander US Capital Markets

Below current benchmarks for stress in leveraged loans

Despite banks’ benign view—at least as of late 2023—broadly syndicated loans are showing signs of stress, at least according to the Morningstar/LSTA index. Loans in default or involved in distressed exchanges over the last 12 months lately tally to 4.33%, up from less than 1% in late 2021. The tally is still short of the 2020 peak and well short of the peaks during the GFC and after the 2001 bursting of the Internet bubble. Reality for the moment is running above bank expectations.

Banks’ opinions in late 2023 might reflect the assumption at the time that the Fed would ease dramatically in 2024, so opinions might change with the next release of the SNC estimates. Nevertheless, owners of syndicated loans with full access to the borrowers’ information took a benign view only a few months ago. That should offer valuable perspective for other holders of loans or for holders of CLO debt. At least recently, the primary lenders like what they see.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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