U.S. regulators on Monday proposed updated guidelines for banks that finance corporate mergers and buyout deals, heightening scrutiny of an area of finance that regulators see as an increasing source of risk.  Joining forces are the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency, who jointly proposed to update guidelines dating back to 2001 for leveraged finance, a source of funding for corporate acquisitions and buyouts by private-equity firms. While this type of lending dissipated in 2008, during the financial crisis, "volumes have since increased while prudent underwriting practices have deteriorated."  The regulators have put out their proposals for public comment;  the comment period ends on 6/8/12. The Proposed Guidelines ... set out broad principles that banks would be expected to follow when participating in leveraged loan deals.  It calls on banks to participate in those that "reflect a sound business premise, an appropriate capital structure and reasonable cash flow and balance sheet leverage." If and when the proposal goes effective, government bank examiners will be able to scrutinize whether banks are complying with these standards - something they're ready to "pounce on" because they say they're concerned about leveraged loan deals that "have frequently included features that provide relatively limited lender protection" in the event a borrower fails to make payments.  In the absence of increase protection, some market participants believe the terms of leveraged loan transactions will become riskier as the economy rebounds and a long-awaited wave of mergers and acquisitions gets into full swing. Where Things Stood Before the Financial Crisis. Private-equity backed buyouts often offered little protection for lenders when borrowers got into trouble.  Those arrangements became known as "covenant lite" - meaning they were missing several of the traditional protections to which lenders had become accustomed.

"It’s understandable that the regulators would like to prevent a recurrence of the aggressive lending that characterized the boom period.  This really comes down to how much self-restraint the regulators will expect the banks to show." -- Martin Fridson, global credit strategist at BNP Paribas Investment Partners.

Which Institutions are Affected. The guidance will affect primarily large institutions because small banks don’t have exposure to leveraged loans.  The regulators said they expect bank managers and boards to identify their institutions’ “risk appetite” for leverage loans, put in place credit limits, and set underwriting standards and valuation standards. Heightened Interest in this Market. The leveraged loan market is off to a solid start this year, with issuance in the U.S. so far around $52.7 billion.  That’s only half the pace of issuance for the first three months of 2011, but it’s up from $30.6 billion in the first quarter of 2010.  Also highlighting the rebound, Markit’s iBoxx USD Liquid Leveraged Loans Index is up more than 4% year-to-date, compared with its historical average full-year return of 5% over the last decade. Recent leveraged loans for refinancing have generally offered better protections for lenders than what was on offer in 2006 and 2007, in part because some of the loopholes that allowed borrowers to pay their owners excess dividends are being left out.  But regulators are worried about a return to pre-crisis standards. For further details:  [WSJournal, 3/26/12].