[House Hearing, 116 Congress]
[From the U.S. Government Publishing Office]


                     EMERGING THREATS TO STABILITY:
                     CONSIDERING THE SYSTEMIC RISK
                          OF LEVERAGED LENDING

=======================================================================

                                HEARING

                               BEFORE THE

                  SUBCOMMITTEE ON CONSUMER PROTECTION
                       AND FINANCIAL INSTITUTIONS

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                     ONE HUNDRED SIXTEENTH CONGRESS

                             FIRST SESSION

                               __________

                              JUNE 4, 2019

                               __________

       Printed for the use of the Committee on Financial Services


                           Serial No. 116-29
                           
[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]                           
                           
                               __________
                               

                    U.S. GOVERNMENT PUBLISHING OFFICE                    
39-449 PDF                  WASHINGTON : 2020                     
          
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 MAXINE WATERS, California, Chairwoman

CAROLYN B. MALONEY, New York         PATRICK McHENRY, North Carolina, 
NYDIA M. VELAZQUEZ, New York             Ranking Member
BRAD SHERMAN, California             PETER T. KING, New York
GREGORY W. MEEKS, New York           FRANK D. LUCAS, Oklahoma
WM. LACY CLAY, Missouri              BILL POSEY, Florida
DAVID SCOTT, Georgia                 BLAINE LUETKEMEYER, Missouri
AL GREEN, Texas                      BILL HUIZENGA, Michigan
EMANUEL CLEAVER, Missouri            SEAN P. DUFFY, Wisconsin
ED PERLMUTTER, Colorado              STEVE STIVERS, Ohio
JIM A. HIMES, Connecticut            ANN WAGNER, Missouri
BILL FOSTER, Illinois                ANDY BARR, Kentucky
JOYCE BEATTY, Ohio                   SCOTT TIPTON, Colorado
DENNY HECK, Washington               ROGER WILLIAMS, Texas
JUAN VARGAS, California              FRENCH HILL, Arkansas
JOSH GOTTHEIMER, New Jersey          TOM EMMER, Minnesota
VICENTE GONZALEZ, Texas              LEE M. ZELDIN, New York
AL LAWSON, Florida                   BARRY LOUDERMILK, Georgia
MICHAEL SAN NICOLAS, Guam            ALEXANDER X. MOONEY, West Virginia
RASHIDA TLAIB, Michigan              WARREN DAVIDSON, Ohio
KATIE PORTER, California             TED BUDD, North Carolina
CINDY AXNE, Iowa                     DAVID KUSTOFF, Tennessee
SEAN CASTEN, Illinois                TREY HOLLINGSWORTH, Indiana
AYANNA PRESSLEY, Massachusetts       ANTHONY GONZALEZ, Ohio
BEN McADAMS, Utah                    JOHN ROSE, Tennessee
ALEXANDRIA OCASIO-CORTEZ, New York   BRYAN STEIL, Wisconsin
JENNIFER WEXTON, Virginia            LANCE GOODEN, Texas
STEPHEN F. LYNCH, Massachusetts      DENVER RIGGLEMAN, Virginia
TULSI GABBARD, Hawaii
ALMA ADAMS, North Carolina
MADELEINE DEAN, Pennsylvania
JESUS ``CHUY'' GARCIA, Illinois
SYLVIA GARCIA, Texas
DEAN PHILLIPS, Minnesota

                   Charla Ouertatani, Staff Director
     Subcommittee on Consumer Protection and Financial Institutions

                  GREGORY W. MEEKS, New York, Chairman

DAVID SCOTT, Georgia                 BLAINE LUETKEMEYER, Missouri, 
NYDIA M. VELAZQUEZ, New York             Ranking Member
WM. LACY CLAY, Missouri              FRANK D. LUCAS, Oklahoma
DENNY HECK, Washington               BILL POSEY, Florida
BILL FOSTER, Illinois                ANDY BARR, Kentucky
AL LAWSON, Florida                   SCOTT TIPTON, Colorado, Vice 
RASHIDA TLAIB, Michigan                  Ranking Member
KATIE PORTER, California             ROGER WILLIAMS, Texas
AYANNA PRESSLEY, Massachusetts       BARRY LOUDERMILK, Georgia
BEN McADAMS, Utah                    TED BUDD, North Carolina
ALEXANDRIA OCASIO-CORTEZ, New York   DAVID KUSTOFF, Tennessee
JENNIFER WEXTON, Virginia            DENVER RIGGLEMAN, Virginia
                            
                            
                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    June 4, 2019.................................................     1
Appendix:
    June 4, 2019.................................................    33

                               WITNESSES
                         Tuesday, June 4, 2019

Gerding, Erik F., Professor of Law and Wolf-Nichol Fellow, 
  University of Colorado Law SchooL..............................     5
Ivashina, Victoria, Lovett-Learned Chaired Professor of Finance, 
  Harvard Business School........................................     8
Nini, Gregory, Assistant Professor of Finance, LeBow College of 
  Business, Drexel University....................................    10
Vasisht, Gaurav, Senior Vice President and Director of Financial 
  Regulation Initiatives, The Volcker Alliance...................     6

                                APPENDIX

Prepared statements:
    Gerding, Erik F.,............................................    34
    Ivashina, Victoria...........................................    57
    Nini, Gregory................................................    71
    Vasisht, Gaurav..............................................    81

              Additional Material Submitted for the Record

Meeks, Hon. Gregory:
    Written statement of Bartlett Collins Naylor, Financial 
      Policy Advocate, Congress Watch, a division of Public 
      Citizen....................................................    85

 
                     EMERGING THREATS TO STABILITY:
                     CONSIDERING THE SYSTEMIC RISK
                          OF LEVERAGED LENDING

                              ----------                              


                         Tuesday, June 4, 2019

             U.S. House of Representatives,
                Subcommittee on Consumer Protection
                        and Financial Institutions,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 2:48 p.m., in 
room 2128, Rayburn House Office Building, Hon. Gregory W. Meeks 
[chairman of the subcommittee] presiding.
    Members present: Representatives Meeks, Scott, Foster, 
Lawson, Porter, Ocasio-Cortez; Luetkemeyer, Lucas, Posey, Barr, 
Tipton, Williams, Loudermilk, Budd, Kustoff, and Riggleman.
    Also present: Representatives Himes and Garcia of Illinois.
    Chairman Meeks. The Subcommittee on Consumer Protection and 
Financial Institutions will come to order.
    Without objection, the Chair is authorized to declare a 
recess of the subcommittee at any time.
    Also, without objection, members of the full Financial 
Services Committee who are not members of this subcommittee are 
authorized to participate in today's hearing.
    Today's hearing is entitled, ``Emerging Threats to 
Stability: Considering the Systemic Risk of Leveraged 
Lending.''
    I now recognize myself for 4 minutes to give an opening 
statement.
    Ranking Member Luetkemeyer and members of the subcommittee, 
welcome to this hearing on, ``Emerging Threats to Stability: 
Considering the Systemic Risk of Leveraged Lending.'' This 
important hearing offers us an opportunity to consider the 
central role that FSOC and the Office of Financial Research 
must play to allow us to monitor, quantify, and map emerging 
systemic risks and designate systemically risky institutions.
    I have been very concerned about the rapid rise of 
leveraged loans and covenant-lite loans in recent years. The 
Fed, the IMF, and many others have referred to these loans as 
recession amplifiers, and I believe we must consider the 
possibility that they may prove systemic.
    When the Federal crisis hit in 2008, one of the central 
drivers of panic was that the public lost faith in the 
regulators' ability to anticipate the next financial 
institution to fail and to contain the spreading crisis. Among 
the many important reforms enacted into law in the Dodd-Frank 
Wall Street Reform Act was the establishment of the Financial 
Stability Oversight Council (FSOC) and the Office of Financial 
Research (OFR).
    FSOC got to the root of one of the obvious problems with 
our pre-crisis regulatory framework--namely, that regulators 
operating in silos cannot effectively monitor for system-wide 
risks or easily implement coordinated response strategies to 
contain the spread of risks.
    Similarly, the capacity to designate non-bank financial 
institutions that pose systemic risks to the system and 
regulate them accordingly is essential.
    Also central to managing risk was the establishment of the 
OFR, which is tasked with monitoring risk in the system 
wherever the risk might originate or lie, quantify the risk, 
map the interconnectedness of the risk, and inform FSOC in its 
monitoring of systemic risk. OFR is not bound solely to the 
banking system and can gather data on financial institutions 
regardless of their regulator or structure. This is essential 
as markets evolve.
    For these reasons, I frankly do not understand the 
Administration's efforts to dilute the role of FSOC and the OFR 
and to gut budgets and staff. We should all aspire to a 
regulatory framework that protects the stability of the system 
as a whole, that is fully informed on existing and emerging 
systemic risk, and is ready to contain any new risk so that we 
protect taxpayers and Main Street. Failing institutions must be 
allowed to fail without threatening the system as a whole or 
bringing down Main Street.
    I look forward to the testimony of our witnesses today and 
to constructive discussion about emerging systemic risk. It is 
important that we discuss the risk that leveraged lending poses 
to the system and whether the regulatory framework we put in 
place following the last financial crisis is adequate or should 
be further updated to ensure that we never again live through a 
crisis that threatens our financial system and capital markets 
as a whole and inflicts the level of financial hardship that we 
witnessed in 2008.
    I will add, in closing, that I am encouraged to see that 
our work, and this hearing specifically, are already having an 
impact, as Treasury Secretary Mnuchin called an emergency FSOC 
meeting over the weekend to discuss leveraged loans and 
exploding corporate credit.
    Specifically, according to this article by Bradley--which I 
will enter into the record--a secret meeting of FSOC was held 
over the weekend as regulators became increasingly concerned 
about the threat that overly leveraged companies will pose to 
the financial system and to the economy in what looks 
increasingly like an accelerated slowdown of the American 
economy.
    I call on FSOC to make public the minutes of the meeting 
and any presentation by staff, including on the risk they see 
to the system and their analysis of comments to their proposal 
to make it harder for FSOC to designate non-bank financial 
institutions as systemically significant.
    I now turn to the ranking member of the subcommittee, Mr. 
Luetkemeyer, for his opening statement.
    Mr. Luetkemeyer. Thank you, Mr. Chairman. And thank you for 
holding a hearing on this important topic.
    Today's hearing is entitled, ``Emerging Threats to 
Stability: Considering the Systemic Risk of Leveraged 
Lending.''
    The keyword for today's discussion should be ``systemic.'' 
While it is no secret that leveraged lending contains a certain 
amount of risk, all lending products do. These hearings should 
focus on whether leveraged lending risk poses a systemic threat 
to our financial system.
    Recently, I have taken note of industry stakeholders and 
regulators who raise concerns regarding the amount of risk in 
the leveraged lending sector. Many of my colleagues echoed 
those concerns at a hearing with prudential regulators last 
month.
    As we assess potential concerns about leveraged lending, it 
is important to take a look at the numbers. The growth rate of 
leveraged lending in 2018 was 20 percent. On its own, that 
number may sound high. However, while comparing it to 
historical growth of leveraged lending since 1997, which is 15 
percent, the rise can be an association with a strong economy. 
As we have heard from Fed Vice Chairman of Supervision Randy 
Quarles, the recent growth in leveraged lending is largely on 
par with the economic growth of this country.
    The total amount of outstanding leveraged loans is 
estimated between $1 trillion and $1.5 trillion. While this is 
another large number, the total amount of outstanding business 
credit is currently $15.2 trillion, making leveraged lending a 
small portion of risk in business lending.
    Furthermore, leveraged lending's 4 percent of the total 
fixed-income markets pales in comparison to mortgage-related 
loans at 22 percent. Not only does leveraged lending encompass 
a small portion of overall fixed-income markets, but the 
systemic significance of leveraged lending is lessened when you 
consider that banks hold less than 8 percent of outstanding 
leveraged loans, according to the Federal Financial Stability 
Report from May of this year.
    So, in other words, you take $1.1 trillion to $1.5 trillion 
worth of exposure, 8 percent of which the banks coming up with 
roughly $100 billion--these are all back-of-the-envelope 
figures here, but roughly $100 billion worth of exposure. The 
Fed's Financial Stability Report recently said that a 2-percent 
loss ratio is an approximate loss ratio in normal economic 
times as we have now, which is $2 billion. I'm not sure that 
the expected loss ratio of $2 billion is systemic to our 
economy. Even at 10 percent, which was what happened in 2008, 
you are looking at $10 billion. So, again, I am not sure $10 
billion is a systemic risk to our economy, but, obviously, we 
are here today to discuss a lot of that as well.
    This evidence suggests little systemic risk to our 
financial markets. However, bank regulators should and are 
still closely monitoring the marketplace and assessing the risk 
associated with leveraged lending. The OCC recently stated they 
remain attentive to heightened risks in the leveraged lending 
market. And FDIC Chairwoman McWilliams stated in written 
testimony before this committee that the FDIC is monitoring the 
market because a significant rise in leveraged loan defaults 
could have broader economic impacts.
    I support the regulators' commitment to oversight of the 
risk associated with leveraged lending. In addition to close 
attention to all financial markets, regulators should continue 
their oversight and supervision of banks to ensure proper risk 
management and capital reserves are in place to appropriately 
protect against leveraged lending risk as well as all loan risk 
on their books.
    I look forward to the discussion on the risk associated 
with leveraged lending and how it affects our financial system.
    With that, Mr. Chairman, I yield back the balance of my 
time.
    Chairman Meeks. Thank you.
    I now yield 45 seconds to the gentleman from Georgia, Mr. 
Scott.
    Mr. Scott. Thank you very much, Chairman Meeks.
    This is a very important hearing. I am very concerned about 
the size of the leveraged loan market and the quality of the 
loans, particularly with regard to the recent increase in what 
we refer to as covenant loans.
    The participation of banks, in contrast to non-bank 
entities, is very important. And the potential challenge that 
highly indebted corporations would face in the event of a 
slowing down of the economy.
    All of this boils down to a discussion of risk, who holds 
it, and who can withstand it.
    Thank you, Mr. Chairman, and I look forward to this 
hearing.
    Chairman Meeks. Today, we welcome the testimony, first, of 
Mr. Gerding, who is a professor of law and Wolf-Nichol fellow 
at the University of Colorado Law School. Mr. Gerding joined 
the University of Colorado Law School in 2011. He teaches 
banking law, contracts, securities regulations, corporations, 
deals, and corporate finance.
    His research interests include: securities; banking law; 
the regulation of financial markets, products, and 
institutions; payment systems; and corporate governance. He is 
the author of a book entitled, ``Law Bubbles and Financial 
Regulation,'' which was published in 2014.
    His research also focuses on the application of technology 
to financial regulation, including analyzing the use of 
technologies such as risk models in governing financial 
markets.
    Second, Mr. Vasisht joined The Volcker Alliance in April 
2014 and serves as the director of financial regulation 
initiatives. In this role, he oversees all aspects of the 
Alliance's work on financial regulatory matters.
    Prior to joining the Alliance, he served as executive 
deputy superintendent of the New York State Department of 
Financial Services, heading the agency's banking division. He 
has also served as the senior deputy superintendent of 
insurance, first assistant counsel, and assistant counsel to 
three Governors of New York, and assistant attorney general in 
the Investment Protection Bureau of the New York State Attorney 
General's Office.
    Third, Ms. Ivashina is the Lovett-Learned Chaired Professor 
of Finance at Harvard Business School, and she is also the 
faculty chair of the Global Initiative for the Middle East and 
North Africa region.
    She is a research associate at the National Bureau of 
Economic Research, a research fellow at the Center for Economic 
Policy Research, and a visiting scholar at the Federal Reserve 
Bank of Boston and the European Central Bank.
    Her research spans multiple areas of financial 
intermediation, including corporate credit markets, leveraged 
loan markets, global banking operations, asset allocation by 
pension funds and insurance companies, and value creation by 
private equity. She is the author of, ``Patient Capital: The 
Challenges and Promises of Long-Term Investing'', and ``Private 
Equity: A Casebook.''
    And last but not least, we have Mr. Nini. He is the 
assistant professor of finance at the LeBow College of Business 
at Drexel University. He teaches classes on financial 
institutions and markets and conducts research in a variety of 
areas related to corporate finance and capital markets. His 
research has been supported by various grants and published in 
the top finance journals.
    In addition to his position at Drexel, he is also a fellow 
at the Wharton Financial Institutions Center, and a visiting 
scholar at the Federal Reserve Bank of Philadelphia. Before 
joining Drexel, he was an economist at the Federal Reserve 
Board in Washington, D.C.
    Witnesses are reminded that your oral testimony will be 
limited to 5 minutes. And, without objection, your written 
statements will be made a part of the record.
    Mr. Gerding, you are now recognized for 5 minutes to give 
your oral presentation.

STATEMENT OF ERIK F. GERDING, PROFESSOR OF LAW AND WOLF-NICHOL 
           FELLOW, UNIVERSITY OF COLORADO LAW SCHOOL

    Mr. Gerding. Thank you, Chairman Meeks, Ranking Member 
Luetkemeyer, and members of the subcommittee, for the 
opportunity to testify about emerging risks to financial 
stability from leveraged loans and CLO markets.
    Financial stability is not merely a technical topic. 
Promoting financial stability is essential to ending the 
squeeze on working families and escaping America's cycle of 
debt. The cycle begins with excessive borrowing. Excessive 
borrowing, even by corporations as in the leveraged loan 
market, impacts working families because it is fed into the 
financial machine.
    Excessive debt makes our financial system unstable. 
Financial market disruptions accelerate economic disruptions, 
from recessions to full-blown financial crises. Economic 
disruptions have a huge and disparate impact on working 
families. Further behind in the wake of a crisis, working 
families must borrow more, and the cycle continues to spin. To 
end this cycle, promoting financial stability is crucial.
    A huge portion of leveraged loans are securitized or used 
to create complex financial products called collateralized loan 
obligations, or CLOs. CLOs are close cousins of the mortgage-
related collateralized debt obligations, CDOs, that were 
central to the global financial crisis a decade ago. Leveraged 
loans and CLOs form a pipeline or system. Disruptions at either 
end of the pipeline can cascade and affect the other market, 
like a spring or crisis accordion.
    The pressing question then becomes: How different is the 
CLO market from the earlier CDO market? There are important 
differences. Pre-crisis CDOs were backed by residential 
mortgages, while CLOs are backed by corporate debt.
    But there are also troubling similarities between the two 
markets. First, underwriting standards in the leveraged loan 
market appear to be deteriorating as covenant-lite loans have 
become prevalent. This mirrors the decline in underwriting 
standards in residential mortgage markets 14 years ago.
    Second, many CLO securities created from leveraged loans 
trade on opaque markets or do not appear to trade at all. In my 
current research, I am surveying the CLO market, spending hours 
on intensive interviews with market participants to learn who 
buys these securities, for what purpose, and whether these 
investors worry about market disruptions.
    Several of my preliminary findings ought to trouble you. 
The most senior investment-grade classes of CLO securities are 
typically purchased by regulated banks, insurance companies, 
and pension funds. This creates a transmission line between 
potential disruptions in the CLO market that could damage the 
broader economy.
    Banking and shadow banking markets are not separate but are 
highly connected. Many senior investment-grade CLO securities 
appear not to actively trade. Those that do trade typically 
trade on primitive, opaque markets with little transparent 
pricing. Why does this matter? Asset-backed securities are 
supposed to be liquid and tradable. Liquidity would allow 
regulated institutions to easily exit the market. Theoretical 
liquidity underpins favorable regulatory treatment of these 
products, including the ability of banks and other firms to 
purchase these investments in the first place, as well as 
favorable capital rules. If liquidity evaporates or was never 
there in the first place, the assumptions that these products 
are safe for banks and insurance companies are questionable.
    A lack of transparent pricing means that investors and 
regulators cannot rely on market prices to police risk 
adequately. Regulators must therefore work much harder to 
police the risk of CLO and leveraged lending markets for 
threats to financial institutions and financial stability.
    I am not confident that regulators have or share among 
themselves the high-quality information that they need, which 
is why I support the three bills that the subcommittee is 
considering today. We cannot wait until we need to man the 
lifeboats to fully fund the iceberg control. We also need to 
ensure that regulators are sharing data with the OFR and with 
each other.
    Thank you very much.
    [The prepared statement of Mr. Gerding can be found on page 
34 of the appendix.]
    Chairman Meeks. Thank you.
    Mr. Vasisht?

STATEMENT OF GAURAV VASISHT, SENIOR VICE PRESIDENT AND DIRECTOR 
   OF FINANCIAL REGULATION INITIATIVES, THE VOLCKER ALLIANCE

    Mr. Vasisht. Chairman Meeks, Ranking Member Luetkemeyer, 
members of the subcommittee, it is an honor and a privilege to 
testify at this hearing to consider the systemic implications 
of leveraged lending.
    Leveraged loans are a key component of business debt. They 
provide credit to companies with high levels of debt or 
speculative credit ratings. In recent years, because of their 
explosive growth and rapidly eroding underwriting standards, 
leveraged loans have increased vulnerability in the financial 
system. In an economic downturn, this vulnerability has the 
potential to disrupt the availability of credit and reduce 
economic output. To address this weakness, regulators should 
take the necessary steps to better understand and mitigate the 
risks of this complex market.
    Usually arranged by a syndicate or group of banks, 
leveraged loans are made to private equity firms or 
corporations mostly to fund a merger or acquisition, pay 
dividends, or effectuate share buy-backs.
    Once made, the loans are sold to investors. The largest 
buyers are collateralized loan obligations, which pool the 
loans and sell the securities based on their cash flow to 
investors globally. Although data is limited, CLO investors 
include foreign and domestic banks as well as non-bank 
financial institutions such as insurance companies, asset 
managers, and hedge funds.
    In recent years, as overall business debt in the United 
States has skyrocketed, so too has the size of the leveraged 
lending market. Fueled by a combination of low interest rates, 
high investor risk tolerance, and low financing costs, 
leveraged loans have grown to a total of approximately $1.2 
trillion, roughly equivalent to the size of the subprime 
mortgage market at its peak.
    As the leveraged lending market has swelled in size, its 
underwriting standards have rapidly deteriorated. So-called 
covenant-lite loans, which lack basic protections for lenders 
and investors, now account for nearly 80 percent of new 
issuances. Moreover, most of the recent growth in lending has 
been concentrated in the riskiest borrowers.
    Late in the credit cycle, as investor risk tolerance and 
asset prices peak, the leveraged lending market could amplify 
losses. In an inevitable economic downturn, as investors pull 
back and the price of speculative debt declines, highly 
leveraged firms will have difficulty obtaining financing and 
repaying their loans. As default rates spike and prices fall, 
firms will shrink their economic output and cut jobs.
    In such a scenario, the stability of the financial system 
would depend on the ability of banks and investors to absorb 
losses. Fortunately, large banks have more capital and 
liquidity than they did before the financial crisis, but 
deregulatory efforts underway since 2017, including regulators' 
retreat from the 2013 leveraged lending guidelines, undermine 
confidence.
    What's more, significant data gaps on CLO investors and the 
lack of a comprehensive analysis of CLO funding structures 
renders a full assessment of potential losses challenging and 
highly speculative.
    What is clear, however, is that in the event of a downturn 
or of sharp asset price declines, the impact on the real 
economy will be consequential even if it doesn't lead to a 
collapse of the financial system and a repeat of 2008.
    For this reason, it is important for policymakers to act 
now.
    First, regulators must better understand the leveraged 
lending market. Put simply, regulators cannot effectively 
regulate something they do not understand. But given the number 
of market participants and regulators involved, it is 
challenging to gather and analyze all the data. I recommend 
that the Office of Financial Research fill any data gaps and 
produce a comprehensive analysis on the risks of the leveraged 
lending market.
    Second, regulators must safeguard the banking system. Since 
banks operate at the core of the leveraged lending market, it 
is important that they remain resilient. I propose that 
regulators reinstate the substance of the 2013 leveraged 
lending guidance and require the Nation's systemic banks to 
build their capital by raising countercyclical capital buffers 
and strengthening the stress-testing process.
    Third, regulators should address risks outside the 
regulatory perimeter. This means that the Financial Stability 
Oversight Council, which was created by Dodd-Frank, should 
withdraw its guidance, which would tie it up in knots and will 
end its ability to designate non-banks.
    Thank you, and I look forward to answering your questions.
    [The prepared statement of Mr. Vasisht can be found on page 
81 of the appendix.]
    Chairman Meeks. Thank you.
    Ms. Ivashina?

    STATEMENT OF VICTORIA IVASHINA, LOVETT-LEARNED CHAIRED 
         PROFESSOR OF FINANCE, HARVARD BUSINESS SCHOOL

    Ms. Ivashina. Thank you, Chairman Meeks.
    To talk about the systemic risk in the leveraged loan 
market, we need to talk about two things: first, whether there 
is risk in the first place; and second, will this risk be 
propagated through the institutions that are holding it.
    Let me start with whether we have signs of concentration of 
hidden risk in the system. There is an important parallel to 
the weakness that characterized the subprime mortgage crisis, 
and that is lack of visibility into the quality of collateral 
backing securitized products. The source of opacity today is 
different than it was in 2008, but it is key to understand that 
the quality of the loans is dictated not solely by the 
fundamentals of the company but also by the credit agreement 
that defines the terms of the loan. These agreements are long 
and complex, and there are substantial variations in 
contracting terms that we observe.
    In a study with my colleague, we see that loans typically 
are characterized by a wide net of negative covenants that span 
six different categories. However, we also find that each 
individual of these negative covenants provisions are commonly 
eroded by what is known in the industry as baskets and carve-
outs. Moreover, we find the prevalence of these baskets and 
carve-outs is much larger for the highly leveraged loans and 
those loans that are backing leveraged buyouts.
    Note that what I am talking about here is very different 
from the covenant-liteness. This is another element of erosion 
of credit agreements.
    With this in mind, the question becomes whether 
institutional investors and CLO managers, in particular, have 
the resources and have the right incentives to do proper due 
diligence on the loans that sit in their portfolios.
    Tension surrounding some of the recent restructurings--that 
includes the restructuring of J.Crew in 2017--indicates that at 
least some of these elements, contractual elements that I 
mentioned are misunderstood by the creditors.
    Beyond increasing contractual complexity, we see other 
elements that would be consistent with an increase in hidden 
risk. The recent rise in corporate leverage was driven by 
growth in the first lien senior secure debt. This is what 
leveraged loans are. In 2007, this layer of debt was capping at 
3.7 times EBITDA. Today, that number is 4.5. Evidently, the 
recovery rate on the 4.5 leverage is much lower than the 3.7.
    What I am saying is that the use of historical recovery 
rates for purposes of volume risk today in the segment would be 
misleading. And, again, the question becomes whether creditors 
that dominate this market are understanding that risk.
    The second parallel to the subprime mortgage crisis is the 
central role of securitization. To be clear, securitization is 
a useful tool that ultimately helps to bring the borrowing cost 
down. However, in any securitized structure, creditors holding 
investment-grade--and for CLOs, that would be close to 90 
percent--do not conduct due diligence, and are not expected to 
conduct due diligence on the underlying portfolio.
    Instead, these investors rely on accuracy of credit rating, 
contractual alignment of incentive between junior and senior 
tranches, and other market mechanisms. Unfortunately, we have 
seen this mechanism fail before. To have confidence in this 
market, we need to understand who is holding equity in CLO 
structures and whether this agent has the right incentives to 
screen and monitor the underlying risk.
    Another point that is relevant for systemic risk is, who 
are the investment-grade investors in CLOs? Do they have stable 
funding? Are they leveraged?
    We are not completely in the dark on this question. We know 
that U.S. banks do not have major direct exposure to CLOs. 
Other large institutions that typically buy investment-grade 
fixed-income are foreign banks and pension life insurers. All 
of these institutions have been known to reach for yield. So an 
educated guess is that these are the institutions behind the 
rise in CLOs.
    We also know that pensions and life insurers are not 
leveraged, they have stable funding, and are generally able to 
withstand temporary market fluctuations. And at least pension 
funds are not financially interconnected institutions.
    It is these elements that lead market observers and myself 
to conclude that, currently, leveraged loans do not present 
elevated risk to the stability of the financial system.
    That is not to say that the prospect that U.S. pension 
funds are exposed to hundreds of billions of tranches in CLO 
structures is not something that should merit a concern on its 
own, especially since the U.S. State pension fund system has 
been known to be in a very vulnerable financial position.
    There is an alternative scenario with several hundreds of 
billions of dollars of CLO tranches sitting in foreign banks. 
That, of course, would have consequences of its own that should 
not be easily dismissed.
    Finally, what I would like to comment is what is likely to 
happen if the CLO market would freeze. And, in my view, there 
are several ingredients that indicate that if the market would 
go through an adjustment, that market would freeze.
    The first point is that the corporate sector is likely to 
face a lot of pressure. And the point that is often 
misunderstood is that most of the contracts actually have 
financial covenants. The covenant liteness merely makes the 
enforcement of the covenants conditional on a set of events, 
which includes acquisitions and raising new financing. But, in 
an economic downturn, a company with a covenant-lite loan might 
avoid the default. Yet, it cannot do much more than that. It 
will be frozen.
    Second, if the leveraged loan market shuts down, there is a 
danger of refinancing. And there has already been an incident 
of this nature in 2008. However, in 2008, the shutdown of the 
CLO market was caused by market dislocation--
    Chairman Meeks. We are out of time.
    Ms. Ivashina. --and it is unlikely that it would be this 
time.
    Chairman Meeks. Thank you.
    Ms. Ivashina. Thank you.
    [The prepared statement of Ms. Ivashina can be found on 
page 57 of the appendix.]
    Chairman Meeks. Mr. Nini?

  STATEMENT OF GREGORY NINI, ASSISTANT PROFESSOR OF FINANCE, 
          LEBOW COLLEGE OF BUSINESS, DREXEL UNIVERSITY

    Mr. Nini. Chairman Meeks, Ranking Member Luetkemeyer, 
members of the subcommittee, thanks so much for the invitation 
to participate in today's hearing.
    Let me start by saying how heartened I am that the 
subcommittee is having a hearing on the relatively arcane topic 
of leveraged loans. Even among business school lunchrooms, 
leveraged loans have only recently become a topic of 
discussion.
    It is my hope today to provide some educational background 
on the topic and to offer some thoughts on whether I think 
leveraged loans creates some unique risks to financial 
stability.
    Interest in leveraged lending has increased in recent years 
because the market has grown so rapidly. Having roughly doubled 
in size over the last decade, the total amount of outstanding 
leveraged loans is now comparable to the amount of outstanding 
high-yield bonds, which is a different product that also 
provides credit to lots of large firms in the United States.
    I think it is important to consider growth in leveraged 
lending in the context of growth of overall corporate credit. 
For example, over the last decade, net new corporate credit has 
risen by about $4 trillion, but the leveraged loan market has 
contributed at most one-fifth of that increase. Moreover, some 
of my research suggests that a lot of the growth in leveraged 
loans reflects from switching away from one type of credit and 
into leveraged loans.
    Of course, it is quite natural that corporate borrowing has 
been so strong in recent years. A healthy economy creates 
demand for borrowing, and low interest rates support the supply 
of credit. Despite this, many measures of corporate credit 
risk--for example, the ability of firms to repay their 
outstanding debt--currently appear quite benign.
    Nevertheless, risk is inherent to all financial markets, 
and if a slowdown in the economy were to happen, the amount of 
corporate defaults would increase, these defaults would be 
concentrated in borrowers with leverage, and investors in 
leveraged loans would certainly suffer financial losses.
    Whether leveraged loans create systemic risk is a different 
question. In the remainder of my time, I wanted to discuss two 
possible sources of systemic risk that I think are unique to 
the leveraged loan market. In each case, I find little evidence 
to be worried.
    First, there is concern that the terms of leveraged loans 
seem particularly advantageous for borrowers and that this may 
reflect aggressive risk-taking by some lenders.
    One particular concern is the creation and surge of so-
called covenant-lite loans. In research I have conducted with 
two colleagues, we find that nearly every firm that has a 
covenant-lite loan has another loan that still has traditional 
financial covenants.
    Leveraged loans come in two parts: one part is a covenant-
lite term loan funded by institutional investors; and one part 
is a line of credit funded by banks that still has traditional 
financial covenants. The second part is often overlooked in 
popular discussions of the leveraged loan market.
    Other measures of conditions in the leveraged loan market 
also do not currently suggest excessive risk-taking. During 
2018, the average interest rate spread on leveraged loans was 
only slightly below its historical average. And spreads have 
risen this year so that the pricing of leveraged loans 
currently does not suggest that loans are particularly cheap.
    A second unique feature of the leveraged loan market is the 
emergence of CLOs as important investors. Economic research has 
highlighted that the financial structure of lenders is a 
potential source of systemic risk, and I do believe it is 
important that we understand how CLOs work.
    In my opinion, CLOs have none of the hallmarks of financial 
intermediaries that could create systemic risk. Although CLOs 
do borrow money to invest in loans, the amount of leverage 
appears small relative to the underlying risk. Indeed, the most 
senior investors in CLOs were spared losses even during the 
height of the financial crisis.
    Moreover, CLOs borrow using long-term debt, so there is 
virtually no risk of a bank run on a CLO. In my opinion, it is 
difficult to envision a scenario in which many CLOs would be 
forced to liquidate large portions of their portfolios in a 
short period of time.
    One realistic concern is that the creation of new CLOs 
could come to a halt during a period of economic stress. This, 
in fact, happened during the financial crisis, which meant that 
many borrowers were unable to issue new leveraged loans. 
However, since the borrowers in this market tend to be large 
firms with broad access to capital markets, they largely 
substituted to alternative sources of credit. I have studied 
this period and find no evidence that borrowers that had an 
institutional leveraged loan suffered any additional adverse 
consequences.
    To sum up, I think developments in the leveraged loan 
market should be monitored in the context of overall growth of 
corporate credit. Although I don't find the level of credit 
alarming at the moment, I am happy to see regulators and 
policymakers actively discussing the topic.
    Second, I view some of the specific changes in the 
leveraged loan market, particularly growth in covenant-lite 
loans and CLOs, as primarily reflecting secular changes in the 
institutional segment of the market rather than a cyclical 
loosening of credit terms or a significant buildup of systemic 
risk.
    Thank you again for the invitation to share my thoughts 
with you, and thanks for proactively monitoring concerns over 
financial stability. I am happy to answer any questions you may 
have.
    [The prepared statement of Mr. Nini can be found on page 71 
of the appendix.]
    Chairman Meeks. Thank you very much.
    And I thank all of the panelists for your excellent 
testimony.
    I now recognize myself for 5 minutes for questions.
    And I will start with you, Mr. Gerding. For me, I don't 
ever want to be put back into a position as I was in 2008 when 
Secretary Paulson came and talked about systemic risk and the 
whole world was falling down. And part of what we wanted to do 
when we did the Dodd-Frank Wall Street Reform Act was to try to 
put in place with reference to the regulators so that they 
could look not only at mortgages but also non-financial 
institutions.
    My question to you is--what we had in mind with FSOC and 
OFR is that they would be a regulatory agency to try to get it 
together. Do you believe that FSOC and OFR have the adequate 
authority to quantify and map the risk that leveraged loans may 
pose to the financial system as a whole?
    Mr. Gerding. I think that they have a number of important 
tools. I am worried that there are a couple of factors that are 
undermining their power.
    One is the subject of one of the bills which your 
subcommittee is considering, which is giving OFR independent 
funding, giving the Director of the OFR the power to have 
independent funding for its agency to set a minimum level. And 
I understand that the bill would also ensure that the funding 
of OFR does not go below that particular level.
    That is critical because OFR is in danger of being hollowed 
out, either by decisions by the Secretary of the Treasury to 
reduce its funding or by staffing losses. I think that is 
important, to ensure that there is a minimum level of funding 
for the OFR.
    The OFR, for me, is one of the most underappreciated 
accomplishments of the Dodd-Frank Act. It essentially created 
an early-warning system for systemic risk and for financial 
crises. So I think making sure that that early-warning system 
functions is crucial.
    One thing that I think is a huge weakness in our regulatory 
regime is not necessarily OFR or FSOC but the incentives and 
the actual data-sharing among Federal financial regulators. I 
hope that this subcommittee pays close attention to whether 
other Federal financial regulators are giving OFR and FSOC the 
critical data that they need to monitor not just banks but non-
bank sources of systemic risk.
    Chairman Meeks. Thank you very much.
    Ms. Ivashina, could you briefly speak to the importance of 
quality data to quantify the risk imposed by the system, by 
leveraged loans, and the limitations in the data currently 
available?
    Ms. Ivashina. Absolutely.
    So, as already mentioned, the window into the leveraged 
loan market that we have is through banking. However, we know 
that banking is not holding much of those CLO tranches. And 
most of the institutions that we can think of that would be 
holding the CLO tranches actually would focus on what is known 
as shadow banking.
    So, first, this data is not collected by regulators. Second 
is that--this is something I have been trying to pursue for 
several months with my colleagues. We have been trying to find 
the private data sets that would address these issues, that 
would give us insight into what is the role of hedge funds, 
what is the role of U.S. State pension funds in this segment, 
and this is something that simply does not exist.
    Chairman Meeks. Thank you.
    And, Mr. Vasisht, can we dismiss outright the systemic 
risks that leveraged loans may pose to the system? Or would you 
say that we could go from merely a recession amplified to a 
systemically disruptive system? What are your thoughts?
    Mr. Vasisht. No, I don't think that we can dismiss that, in 
large measure because of how opaque leveraged lending is and 
how opaque CLOs are.
    We don't fully understand or, actually, fully appreciate 
the role that banks play in this market. They underwrite the 
loans. They sell the loans to CLOs. They then invest in the 
CLOs. And they hedge their risk in terms of holding the loans 
as well as being investors in those CLOs.
    One common narrative that I have heard is that banks don't 
really have much risk and they are not exposed to it. Banks are 
exposed to it. And the reason I bring it up is because 
recessions caused by instability in the banking system last 
longer and are deeper than other recessions.
    One thing that really does need to be explored is how 
exposed the banks are. It may be that they are not too exposed 
and we don't have anything to worry about. But, at this stage, 
given the opacity of the market, I am not comfortable making 
that statement.
    Chairman Meeks. Thank you.
    I now yield to the distinguished gentleman from Missouri, 
the ranking member, Mr. Luetkemeyer, for 5 minutes.
    Mr. Luetkemeyer. Thank you, Mr. Chairman.
    I don't know really where to start here. Let me talk with 
Mr. Nini, I think, from the standpoint that I am concerned--we 
have a situation where we are talking about loans that are 
being made. And with every loan, there is risk. And that is 
what banks do. They make loans and assess risk and whether they 
want to do it or not. That is the nature of their business. 
That is their business model.
    And they make their loans and--you made a comment a minute 
ago that was really intriguing from the standpoint--you said, 
even if there is a downturn and we no longer are able to do 
this, to make leveraged loans, that those entities would 
probably go to another market. They would probably go to the 
equities market to get the cash they need to be able to 
continue to--it would be a different source of funding, but 
these loans probably would not be necessarily as risky because 
they probably wouldn't go under quite as quickly as, say, a 
mortgage loan, which people really don't have anyplace else to 
go. If you have a home mortgage and suddenly you lose a job, 
you wind up with something upside-down in your loan portfolio.
    Could you elaborate on that just a little bit? I am trying 
to get a grasp on how the--and the systemic part of that, then. 
If there is really not much risk from the standpoint that they 
really probably don't have as much risk in a leveraged loan 
because there is ability to continue to shore up the business 
entity, there is not as much risk there, in my thought process. 
Am I wrong on that, or is that about right?
    Mr. Nini. Your sentiment is very much right.
    The borrowers in the leveraged loan market are some of the 
largest in the United States. Many are publicly traded firms. 
Many have access to the corporate bond market. And all will 
have a line of credit, an existing line of credit, with a bank.
    In the financial crisis, 2009-2010, there were virtually no 
new CLOs created. They are the biggest buyers of leveraged 
loans. And so that put a pretty big damper on at least the 
institutional part of the leveraged loan market. These firms 
that had existing leveraged loans had trouble refinancing them 
or getting a new one.
    I examine them and compare them to other firms that did not 
have institutional leveraged loans, and I find no adverse 
consequences in terms of investment, stock prices, employment. 
And the reason is because they were able to use these other 
sources of credit, either borrowing in the corporate bond 
market, borrowing from a bank. These are big firms, again, and 
so they are able to substitute across fairly easily.
    I think it is a risk to consider about, a freeze-up of 
markets. But this one in particular, because of the nature of 
the borrowers, at least during the financial crisis, it didn't 
seem to prove too problematic.
    Mr. Luetkemeyer. The loss ratios, those seem to bear out a 
systemic risk. There is obviously a risk there, and our economy 
would take a hit. But, systemically, to throw it into a 
downturn or a tailspin even further, it doesn't seem like there 
is enough there to actually cause that to happen.
    Mr. Nini. It is important to remember that loans are one of 
the safest investments that exist in capital markets. They do 
carry risk, of course, and banks are good at assessing that. 
But as Professor Ivashina said, they are often the most senior 
part of a firm's capital structure. Default rates, 
historically, on leveraged loans have been only about 3 
percent. And in the event of a default, the losses happen to be 
quite small.
    Mr. Luetkemeyer. Okay.
    Mr. Vasisht, you have talked a couple of different times 
and said that the regulators don't understand how to look at 
leveraged loans and you need OFR to do that. And you were 
talking about the markets, and you didn't really feel the 
regulators could do their job.
    I am kind of concerned about that comment, number one. And, 
number two, if that is true, that the regulators don't have 
enough background to understand what they are actually looking 
at, should we regulate to solve the problem or should we 
legislate to solve the problem?
    Ms. Ivashina. So--
    Mr. Luetkemeyer. No, I am talking to Mr. Vasisht.
    Ms. Ivashina. Oh, sorry.
    Mr. Vasisht. I think--
    Mr. Luetkemeyer. Maybe I misunderstood you.
    Mr. Vasisht. Yes, I think a little bit. What I was saying 
was, you can't regulate something that you don't fully 
understand. And that is a comment not on the regulators but 
more on the lack of data in this market.
    If you don't fully have a picture of what is going on in 
the market--so, for instance, we don't know fully who the 
investors in CLOs are. We know that. There are some things we 
know, and one of the things that we know is that we don't fully 
know who the investors are in the CLOs--
    Mr. Luetkemeyer. I apologize. My time is about up here, but 
I want to get to--the heart of the question is, okay, to solve 
the problem you are talking about here, do we legislate to 
solve this problem, or do the regulators go in and regulate and 
propose rules on how they can better analyze and regulate those 
loans?
    Mr. Vasisht. In this instance, I think the issue can be 
resolved with the Office of Financial Research and the powers 
that it was given under Dodd-Frank. The only issue is, does it 
have the desire, the incentive, and the funding to actually do 
that?
    Mr. Luetkemeyer. Okay. Thank you.
    Chairman Meeks. The gentleman's time has expired.
    I now recognize the gentleman from Georgia, Mr. Scott, for 
5 minutes.
    Mr. Scott. Thank you very much, Mr. Chairman.
    I think we are putting our hands right on the issue here, 
because I think the most important thing in this hearing is 
understanding that this is about risk.
    And, Mr. Vasisht, as you pointed out, it is not just about 
risk but understanding who is taking this risk and making sure 
we have the data available to be able to understand it.
    And with that in mind, Fed Chair Powell, to give us some 
understanding of this, he said that right now there is $90 
million of this CLO business. But he also said that only--$700 
billion, I am sorry, in a total market of the CLOs. But only 
$90 billion of that roughly $700 billion are held by the 
largest banks. So that comes out to being about 13 percent of 
all of the CLOs.
    The question, it seems to me, is, does this mean that our 
major domestic financial institutions are being protected from 
the harshest impacts in the event of a financial shutdown? But 
it also follows that these other non-bank participants in this 
market, be it mutual funds, pension funds, or insurance 
companies, may feel the pinch in the downturn.
    So the question is, to each of you, what do we know about 
the portion of the CLO market that is taken up by these non-
bank entities? What do we know about them? We know that 13 
percent are handled by our banks, our largest banks. What about 
this remaining 87 percent? What do we know about these non-bank 
entities?
    Can we start with you on that, Ms. Ivashina?
    Ms. Ivashina. This is precisely the question. So we have 
inside of the banks, we take them out, and the bulk of CLO 
tranches is still left out. I would make that point that you 
are raising a little bit more complex one, because part of this 
is investment-grade, which is the bulk, but the layer of the 
equity, which is definitely not sitting in banks, will be also 
very important to gain insight.
    We don't know much. This is why the system is known as--why 
this is generally described as shadow banking. And, in 
particular, one question to put out there: How much of that is 
sitting in U.S. State pension funds? That would be an important 
question.
    Mr. Scott. Yes. And my issue is, how can we make sure that 
these people who rely on their pensions, on their retirement 
funds, are adequately protected? Not just the banks, but these 
are people there who are suffering.
    Let me give you an example. We have many union members 
right now who are pensioners. Do we know if they are in this 
position because the money is not there? Particularly, the 
Teamsters. The Teamsters pension is basically gone. We are 
having to adjust to that. To what degree were they in this 
leveraged loan market? How can we make sure that Main Street, 
the people who are depending upon this, are protected?
    Mr. Vasisht, you made an interesting point, because I think 
you are driving home what I am after here. Do you think we have 
enough information on these participants who are non-banks, who 
are in real deep in this market? Are they adequate to be able 
to handle the risk?
    Mr. Vasisht. Yes, I think that there is not sufficient 
information at this stage to fully understand the non-banks. I 
can tell you that the non-banks that invest in CLOs include 
insurance companies, pension funds, mutual funds, hedge funds, 
and others. But it would be good to better understand what the 
exposures are and whether the investors themselves, those 
investors, have runnable funding structures. So not the--
    Mr. Scott. Let me just end--
    Chairman Meeks. The gentleman's time has expired.
    Mr. Scott. Mr. Chairman, is it possible that I could get 
just one little question? I just wanted to know if the 
panelists were aware of the information that Fed Chair Powell 
said, that only 13 percent are covered by the major banks.
    Chairman Meeks. Just answer yes or no, if you are aware.
    Mr. Nini. Yes.
    Ms. Ivashina. Yes.
    Mr. Vasisht. Yes.
    Mr. Gerding. I think banks own 45 percent of leveraged 
loans--
    Chairman Meeks. The gentleman's time has expired.
    Mr. Scott. Thank you very much, Mr. Chairman, for your 
generosity.
    Chairman Meeks. I now recognize the gentleman from 
Kentucky, Mr. Barr, for 5 minutes.
    Mr. Barr. Thank you, Mr. Chairman.
    Professor Gerding, in your testimony, you identify CLOs as 
``close cousins'' of mortgage-related CDOs that were at the 
heart of the global financial crisis.
    From 1993 to 2018, do you know how many principal 
impairments were recorded for the 9,181 tranches issued by U.S. 
CLOs over those 26 years?
    Mr. Gerding. I don't have that data.
    Mr. Barr. I can tell you what the answer is. It is 53--53 
impairments out of 9,181, or .58 percent. And that includes 
defaults during the period of the worst financial crisis since 
the Great Depression.
    Mr. Vasisht, you have attempted to conflate CLOs with other 
very different asset classes that were actually at the heart of 
the 2008 financial crisis, namely, subprime residential 
mortgage-backed securities, credit default swaps, and other 
squared structures like collateralized debt obligations (CDOs).
    Do you know how many triple-A- or double-A-rated CLO 
tranches have defaulted over the last 26 years?
    Mr. Vasisht. I don't have that data.
    Mr. Barr. The answer is zero, not a single default, 
including during the worst financial crisis since the Great 
Depression.
    And the reason why CLO debt securities had performed so 
well--and, by the way, your concern about bank investment in 
CLOs, they only invest in triple-A and double-A tranches. The 
reason why CLO debt securities have performed so well 
historically, even in times of economic distress, is very 
simple: CLOs bear absolutely no resemblance to the toxic CDOs 
that preceded the financial crisis. In fact, CLOs performed 
very well during the crisis.
    And this is because CLOs are straightforward, long-term-
only investment funds, professionally managed by SEC-registered 
investment advisors that typically hold 90 percent of their 
assets in senior secured commercial industrial loans. These are 
not residential mortgage-backed securities, subprime, no-doc 
loans. These are first-lien, senior secured industrial and 
commercial loans in well-known American companies with high 
levels of collateral.
    Mr. Nini, can you discuss the diversification of CLOs and 
the alignment of interest between CLO managers and CLO 
investors that differentiate CLOs from CDOs?
    Mr. Nini. Sure. The leveraged loan market spans a wide set 
of firms across many, many different industries and locations. 
This provides lots of ability for CLOs to invest in a very 
broadly diversified set of loans. And they all do. They all 
have rules that require them to do so, and they hold very well-
diversified portfolios.
    The managers of the CLOs, who are charged with selecting 
those loans, have compensation which looks very much like an 
equity exposure in the CLO. This puts them on the hook for risk 
if things go bad; their compensation falls.
    Mr. Barr. Right.
    Mr. Nini. The obvious intention of this is to give them 
incentives to do a good job.
    Mr. Barr. Right. In fact, CLOs are actively managed, and 
there is a perfect alignment of interest between the CLO 
manager and the CLO investors, because the CLO manager is paid 
only after the note holders are paid.
    Finally, let me just make this point. And, by the way, 
there is diversification. Typically, no more than 3 percent of 
their portfolios in the loans are in any single borrower and no 
more than 15 percent in any single industry sector. That is 
fundamentally different than mortgage-backed securities, where 
there was no visibility, number one, but, number two, they were 
all concentrated in a single residential real estate market.
    Finally--this is an important point--because CLOs are long-
run, non-mark-to-market investors, they are term structures. 
And that means they represent locked-up money that can 
withstand and, in fact, provide liquidity in stressed market 
environments. So, in a downturn, CLOs actually stabilize the 
market by acting as a buyer when the rest of the market is 
looking to sell.
    It is problematic that nobody understands this, it seems, 
in this room, except for Mr. Nini. CLOs are long-term capital. 
They are not subject to short-term redemptions or outflows. 
And, in this regard, CLOs provide a vital source of liquidity 
in a downturn. This is exactly the kind of structure that 
policymakers should want.
    So, I don't get it. These are high-performing. They are 
liquidity providers in a downturn. They represent the long-
term, non-mark-to-market investors. And why does this matter? 
Because 72 percent of all American companies are non-
investment-grade. Leveraged loans provide $1.7 trillion in 
financing to American companies, and most of the commercial 
credit in the market comes from non-banks.
    Because Dodd-Frank regulation is limiting the amount of 
leveraged loans a bank can take on, the capacity of non-banks 
to fill the liquidity gap becomes that much more important. If 
non-bank lenders become constrained, then guess what? Funding 
costs will go up. If funding costs go up, bankruptcies happen. 
If bankruptcies happen, there are less jobs, there are lower 
wages. That is not good for financial stability. Over-
regulation of CLOs would be an impediment to financial 
stability.
    And my time has expired. I have more questions, but my time 
has expired, and I yield back.
    Chairman Meeks. The gentleman from Illinois, Mr. Foster, is 
now recognized for 5 minutes.
    Mr. Foster. Thank you, Mr. Chairman.
    And thank you to our witnesses. I think you are probably 
seeing pretty clearly the difference between Members who were 
actually here in this committee during the financial crisis and 
those who heard a rather different, after-the-fact rewrite of 
it.
    Many previously safe financial products became unsafe 
during that crisis, and very few people had a clear idea. It 
remains one of the unsolved problems of the financial crisis. 
For example, how will we rate these things? How will we avoid 
the ``issuer pays'' conflict that is intrinsic and is on the 
relatively short list of problems that we didn't solve?
    Now, in the last few years, Treasury has downsized the 
Office of Financial Research, which should remain one of the 
key ways that we keep our eye on emerging risks. This obviously 
limits the Office's ability to gather and analyze financial 
market data, like the leveraged lending market and others.
    Specifically, President Obama's Fiscal Year 2017 budget 
provided for an OFR with a staff of 255. President Trump's 
Fiscal Year 2020 budget estimates 145 employees. This 
represents a staff budget reduction of more than 43 percent.
    Professor Vasisht has commented on the fact that we just 
don't have the data we need in many of the markets, like CLOs 
and direct leveraged loans.
    And so my first, I think, simple question is: Do you agree 
that the Office of Financial Research needs to be well-funded 
to fulfill its purpose to collect and analyze information about 
opaque markets such as leveraged lending or CLOs?
    Mr. Vasisht. It is absolutely critical that that happen.
    Mr. Foster. And so should Congress consider legislation, 
such as the discussion draft that I am cosponsoring and intend 
to introduce, to ensure that the OFR has independent and 
sufficient funding to gather data on leveraged lending and CLO 
markets and other emerging threats?
    Mr. Vasisht. Funding and desire are key components, and I 
think that legislation would address both.
    Mr. Foster. Thank you.
    How about the idea that the OFR or the various Federal 
financial regulators periodically stress-test certain non-bank 
markets, such as those for CLOs or complex asset-backed 
securities? Do you think this would be helpful for policymakers 
to have a better assessment of potential systemic risks?
    Mr. Vasisht. Absolutely, it would be very helpful. One of 
the problems with stress-testing is that second-order effects, 
indirect effects, are not fully appreciated in stress-testing, 
so--
    Mr. Foster. Correlations between assets.
    Mr. Vasisht. Yes.
    Mr. Foster. That was one of the biggest things that almost 
everyone missed, is the correlation of different tranches.
    And so, if I could go back a little bit more, who currently 
gives ratings to the CLOs?
    And is there any proposed cure for the ``issuer pays'' 
conflict that bedeviled us during the Dodd-Frank time, trying 
to find a way around that intrinsic problem? Are any of you 
familiar with a plausible fix to this? Anyone who wants to--
    Mr. Gerding. I think we should be exploring other 
alternatives to credit-rating agencies. There are a lot of 
proposals out there. It is a very complicated issue, but one 
potential way of looking at this is looking at market prices, 
credit spreads, spreads on credit default swaps.
    One of the--
    Mr. Foster. One of the lessons we learned is, using the 
spread, the credit spread, as any measure of the real risk, 
there are times when the market gets things badly wrong.
    Mr. Gerding. That is absolutely right.
    Mr. Foster. And not to mention, using LIBOR as a reference, 
which was--you know, during the crisis, every one of us woke up 
every day and looked at the LIBOR TED spread and then 
discovered later that the LIBOR thing was just completely 
fictitious and literally made up over lunchtime.
    This is why you need sophisticated entities like the Office 
of Financial Research, looking in detail at things that, 
frankly, the average Member of Congress and perhaps even some 
of the regulators don't have time to look into.
    Any other comments on the ``issuer pays'' problem with the 
rating agencies? Do any of you have a favorite solution to that 
that you could name?
    Ms. Ivashina. It doesn't have to be one thing. There are 
several mechanisms. Of course, credit-rating agencies are very 
important, but so are the market forces, so is visibility into 
the incentives of the junior tranches we try in charge of 
collecting the information.
    Mr. Foster. Okay. Thank you.
    Mr. Gerding?
    Mr. Gerding. I don't think we should rely on just one 
source. I think that is a mistake, to rely just on ``issuer 
pay'' credit-rating agencies. I would prefer that financial 
regulators rely on multiple sources.
    Mr. Foster. Yes. So, if you have time, if you could answer 
for the record, just point our staff at a few papers that 
describe what you think are plausible solutions to this. 
Because I know I have been thinking about it without success 
for the last decade.
    Chairman Meeks. The gentleman's time has expired.
    The gentleman from Colorado, Mr. Tipton, is now recognized 
for 5 minutes.
    Mr. Tipton. Thank you, Mr. Chairman.
    Mr. Nini, in your testimony, you commented that in a 
downturn, there will be losses. So, to the point of the hearing 
today, wouldn't an economic downturn pose significant risk to 
investigators and institutions with leveraged loans on their 
balance sheets?
    Mr. Nini. Likely, yes. During economic downturns, corporate 
defaults do increase. In the last 2 recessions, corporate 
defaults reached about 8 percent, and investors in those loans 
suffered losses. And I expect that would happen in the future.
    Mr. Tipton. And would that pose a significant risk to those 
investors and institutions? Is it going to be systemic?
    Mr. Nini. A systemic risk? They would lose money, which 
they probably wouldn't like. Whether that creates a systemic 
risk, I believe, is a different question.
    The CLOs, which hold a fair amount of the risk, I do not 
believe are a source of systemic risk. Mutual funds hold some 
of this risk. I don't believe they are a huge source of 
systemic risk. And then banks and other investigators hold some 
of the risk, and I think our regulators are monitoring them to 
see if there is any source of risk there.
    Mr. Tipton. I appreciate that, because that is actually at 
the crux of what we are having the hearing on today, on the 
CLOs, are they going to be actually becoming a systemic risk to 
the economy. And your answer, effectively, is that you would 
have losses but it is not going to be systemic?
    Mr. Nini. That is right.
    Mr. Tipton. Okay.
    Is it your understanding that the prudential regulators 
that we currently have are monitoring the leveraged loan 
lending market and having the tools necessary to be able to 
identify and mitigate the risk to the financial markets?
    Mr. Nini. I believe it--let me stress one thing, is that 
most leveraged loans are arranged by commercial banks, large 
Wall Street banks, which are under regulatory surveillance. So 
this means that it is very unlikely that the origination of 
leveraged loans would escape oversight from regulators at the 
origination point. The Shared National Credit Program allows 
exiting bank regulators a very large amount of oversight at the 
origination of many leveraged loans.
    I find it quite telling that the large regulators, 
including the systemic risk regulators, FSOC and OFR, in their 
recent reports, all look at leveraged lending and are clearly 
thinking about the risks that leveraged lending might play in a 
crisis.
    Mr. Tipton. Okay. Thank you.
    And, further, are you concerned that calling leveraged 
lending ``systemic'' could implicate the countercyclical 
capital buffer?
    Mr. Nini. I am not sure just labeling it ``systemic'' might 
trigger that. I think regulators are thinking carefully about 
whether leveraged loans might warrant the countercyclical 
capital buffer independently of exactly how they are labeled.
    Mr. Tipton. Thanks.
    And, ultimately--and this is something that always concerns 
me, coming from a rural area--if we were to label that as 
``countercyclical,'' the requirements on the banks to be able 
to put more capital in, that would ultimately result in higher 
costs for consumers if there is a downturn, wouldn't it?
    Mr. Nini. That, for sure, is the concern. In my personal 
opinion, countercyclical capital requirements are a fairly 
blunt tool to deal with what is a somewhat modest risk of 
leveraged lending. Capital requirements would affect all the 
products the banks offer, including lots unrelated to corporate 
lending, and the potential for increase in costs would be very 
widespread.
    Mr. Tipton. Okay. Thank you.
    And I yield the balance of my time to Mr. Barr.
    Mr. Barr. I thank my friend from Colorado.
    Mr. Nini, let me follow up on the point that I was making 
towards the end of my questions, and that is the unique 
characteristic of CLOs in that they are long-term, non-mark-to-
market investors. They represent non-mark-to-market investors.
    Can you comment on how that structure could provide 
liquidity in a downturn and, in that sense, provide a 
stabilizing impact on the market?
    Mr. Nini. Yes. It is very important to note that 
collateralized loan obligations, they borrow money at 
maturities longer than the maturities of the loans that they 
hold. This means they are rarely going to be forced to repay 
some outstanding debt.
    During the end of 2018, when there was some volatility in 
markets, CLOs were buyers of loans at low prices, playing the 
exact role that you point to. The fact that they can't 
experience a run does have the potential that they can be a 
stabilizing force during--
    Mr. Barr. And does this explain why CLOs performed so well 
during the financial crisis?
    Mr. Nini. I believe it is one of the factors. There were 
some mark-to-market CLOs that existed pre-crisis. Those have 
gone away and don't exist anymore--
    Mr. Barr. They don't exist anymore.
    Mr. Nini. --because they don't make sense.
    Mr. Barr. I yield back.
    Chairman Meeks. The gentleman's time has expired.
    The gentleman from Florida, Mr. Lawson, is now recognized 
for 5 minutes.
    Mr. Lawson. Okay. Thank you very much.
    And welcome to the committee.
    My concern will be for the whole panel. When you go back to 
2007, when the financial crisis pretty much hit, what is the 
difference in subprime lending now compared to back in 2007 
that would lead you to, in some of your testimony, say today 
that we might be headed towards another crisis? Which I really 
don't understand.
    And I will start with you, Mr. Gerding, and we will go down 
the line. If you could explain it to me, so I have a clearer 
picture?
    Mr. Gerding. We have discussed quite a bit at this hearing 
that the leveraged lending market is different than the 
mortgage lending market. There might be some benefits, some 
reasons that the leveraged lending market is less systemically 
important, but just because the financial crisis impacted 
mortgages and not leveraged loans and CLOs doesn't mean that 
this time is necessarily different.
    A shock that affects corporate borrowing rather than real 
estate mortgages could affect this market in ways that the CLO 
market and leveraged loan markets were not affected 10 years 
ago. So it is important to look at similarities and differences 
and ways in which this market might be less risky but also, in 
some ways, more risky than the mortgage lending market.
    One thing that Dodd-Frank did is it regulated the quality 
of consumer mortgages. Leveraged loans were not similarly 
regulated or addressed in post-crisis reforms.
    Mr. Lawson. Okay.
    Would anyone else like to respond?
    Mr. Vasisht. I will respond.
    There are clearly differences. There are similarities, and 
those similarities are striking, but there are also significant 
differences.
    Those differences might make dealing with leveraged loans 
easier than sub-prime mortgage-backed securities in the pre-
crisis era, but you still have to deal with it. Just because 
there are differences and they might be mitigating factors 
doesn't mean that you can be complacent about it and ignore it 
until it balloons into a problem.
    I think one of the key reasons why it is important to have 
a hearing like this is to discuss what is missing, what 
information is missing. How do we get our hands around that 
information, analyze it, so that we can make statements like 
CLOs are not runnable, that their investors are not going to 
pull back and have their own funding problems; how exposed 
banks actually are to this market, including the lines of 
credit they provide to non-banks that invest in CLOs?
    What happens when a non-bank entity that invests in a CLO 
has stress? What impact would that have on the bank and on the 
banking sector? These are key questions that still need to be 
answered. We need information to do that.
    Mr. Lawson. So, from your standpoint, I can't say it solved 
it, but Dodd-Frank brought all of this out.
    And, from the consumer standpoint, the ones that suffer so 
much from mortgage foreclosures and losing houses and, most of 
all, the investment, are we on the right track?
    Ms. Ivashina. I can take this question.
    From the consumer's standpoint--and this is important to 
emphasize. The consumer here--again, for me, it comes through 
the investment into investment-grade alternatives. The point 
that was raised earlier is that the losses on the investment-
grade tranches will not be large. That is true. But if these 
losses fall into already vulnerable entities--now, we know they 
are not leveraged entities. They are entities with stable 
funding. But the U.S. retirement system is vulnerable from a 
financing standpoint. And so, if these losses fall into 
entities that are already weak, that could trigger an effect on 
the broader population and on the consumers.
    Mr. Lawson. Okay.
    Did you want to comment, Mr. Nini?
    Mr. Nini. No. I agree with my colleagues.
    Mr. Lawson. Okay.
    Okay. With that, Mr. Chairman, I yield back.
    Chairman Meeks. The gentleman yields back.
    The gentleman from Texas, Mr. Williams, is now recognized 
for 5 minutes.
    Mr. Williams. Thank you, Mr. Chairman.
    The economy is booming. Businesses are able to access 
credit. There are more job openings than workers. And our 
economy grew at the fastest pace in almost a decade last year. 
To me, as a small-business owner on Main Street for 50 years, 
it would seem logical that, as the economy grows, so does the 
use of leveraged lending.
    Mr. Nini, how do you think we should be correlating the 
prevalence of leveraged loans to risks that they pose to the 
financial system? And are there any specific indicators you 
think we should be paying attention to?
    Mr. Nini. I agree with your assessment that the pace of 
growth of corporate borrowing has largely tracked what is 
happening with the economy. A strong economy creates demand for 
borrowing, and the level of borrowing that we see is not 
dissimilar from what we have seen at other points of economic 
expansions in the past.
    In my opinion, we should be and regulators should be 
monitoring overall growth in corporate credit. There is some 
academic research suggesting that large increases in credit 
growth can proceed and exacerbate downturns. Leveraged loans 
are just one fairly small part of that that should be 
considered in the broad context of overall credit.
    Mr. Williams. Thank you.
    There have been significant changes in financial regulation 
since the 2008 crisis. Our banks are now better capitalized and 
more aware of risk than ever before. In the Federal Reserve's 
``Financial Stability Report'' that was released in May, it 
states the following: ``With regard to leveraged lending, banks 
have improved their management of the associated risks.''
    So, Ms. Ivashina, can you explain the difference between 
corporate loan scrutinization and the securitization of 
mortgages and how the risk profiles of each are different?
    Ms. Ivashina. I generally find a comparison between 
mortgages and corporate loans to be something to be done super-
carefully. But there are two elements on each way to compare. 
And in mortgages, in particular, there was lack of visibility 
on what lies inside the securitized mortgage obligations. The 
reason for that was, amongst several other things, corrupt 
origination practices. What happens in the loan market, of 
course, is very different. You deal with public companies, our 
secondary markets. These are sophisticated agents.
    However, what underpins the risk, not only from the members 
of a public company but also the credit agreement--and this is 
where the contractual weakness comes in and the complexity of 
the contracts goes beyond the covenant-liteness that we have 
been emphasizing. This was part of my statement.
    This is one parallel between mortgages and loans, and that 
is lack of visibility, potential lack of visibility, in what 
goes into the pool.
    And the second element here is that, as in any securitized 
mortgages or in loans, its equity piece, the most junior piece, 
is that one of the key elements for assuring that the system is 
functioning.
    Mr. Williams. Okay.
    Many of you on this panel have noted the increase in 
covenant-lite loans in this market.
    Mr. Nini, in your testimony, you mentioned that the growth 
in leveraged loans has been a result of investors substituting 
away from other forms of debt. So what do you see as the main 
cause of this phenomenon? And do you believe our financial 
regulators are properly equipped to deal with this trend?
    Mr. Nini. In my opinion, the emergence of covenant-lite 
loans reflects a convergence with the high-yield bond market. 
High-yield bonds, which firms have used forever, would be 
considered a covenant-lite product. They do not have financial 
covenants the same way that bank loans do.
    A similar phenomenon is happening for leveraged term loans, 
which are being sold to institutional investors--the very same 
investors that participate in the high-yield bond market who 
understand these products very well. I recently visited some of 
our regulators and talked about my research. I think they are 
very much on top of it.
    Mr. Williams. Okay.
    Mr. Chairman, I yield my time to my colleague, Mr. Barr.
    Mr. Barr. Thank you. I appreciate my friend from Texas 
yielding.
    Ms. Ivashina, I wanted to explore this issue, which I think 
is a very important one, that you raise about lack of 
visibility. Because, of course, that was a major problem during 
the financial crisis, the lack of visibility with respect to 
RMBS and the originate-to-distribute model.
    That is not what we have here. This is not originate-to-
distribute. These are professionally managed, and there is a 
high level of visibility, unless I am missing something, in 
terms of these being a senior secured commercial industrial 
loans into companies that provide financial audited reports to 
these professional managers. And they are not squared 
structures. There are no CDOs; there are no credit default 
swaps on the other end. They are just long-term.
    Why do you say there is a lack of visibility? Or, 
relatively speaking, wouldn't you concede there is greater 
visibility into these products than those subprime RMBS?
    Ms. Ivashina. On the one hand, the fundamentals are more 
observable as a company. But, on the other hand, for each loan, 
we have to understand 200 pages of very complicated legal 
language. This is not only covenant-liteness, which concerns a 
very small fraction of the contract, but basket carve-outs and 
other forms of erosion on each one of the negative covenants 
that you would need to do for 100 loans that sit in a CLO and 
for each of the investors and investment-grade to understand 
that. That is the similarity with the mortgage market.
    Chairman Meeks. The gentleman's time has expired.
    I now recognize the gentleman from Georgia, Mr. Loudermilk, 
for 5 minutes.
    Mr. Loudermilk. Thank you, Mr. Chairman.
    And thank you all for being here today.
    And, yes, this is a topic that I think we need to address, 
but we need to make sure that our businesses have sufficient 
access to credit, especially in a time when we are seeing the 
economy go in the direction it is going. One of the ways that 
you can bring a halt to a growing economy is to make sure that 
the small businesses don't have access to the credit they need 
to continue to grow their businesses.
    To Mr. Nini, when you compare this to other credit classes 
like auto loans, student loans, and mortgages, how much 
outstanding debt is present in leveraged loans as compared to 
those other types?
    Mr. Nini. The outstanding amount of leveraged loans, I 
estimate at about $1.8 trillion, which includes a portion that 
is funded by banks and a portion that is funded by non-banks.
    I am not exactly sure about the size of those other 
consumer credit markets that you reference. I believe they are 
a bit smaller in their order of magnitude.
    Mr. Loudermilk. Okay. This is something I would like to 
investigate to see where that continues. I think that would be 
worthwhile of us looking into that.
    Also, while the vast majority of leveraged loans are now 
made by non-banks, are non-banks still thoroughly regulated by 
the SEC/FSOC in the States?
    Yes, Mr. Nini?
    Mr. Nini. The large non-bank institutions in the leveraged 
loan market are CLOs that we have talked a bunch about and 
mutual funds, each of which will have some regulatory coverage 
by the SEC.
    Mr. Loudermilk. Okay.
    Again, Dr. Nini, what is the typical rate of losses on 
leveraged loans during good economic times?
    Mr. Nini. During good economic times, it will be less than 
2 percent. In recent years, it has been on the order of 1 
percent, 1.5 percent.
    Mr. Loudermilk. What about comparative to a recession?
    Mr. Nini. In a recession? In the last 2 recessions, the 
default rate has increased to about 8 percent. Again, in a 
default, senior loan investors typically don't lose all of 
their money. They are senior; they have collateral. They 
typically recover 70, 80 cents on the dollar. So the losses 
they have are going to be much smaller even than that 8 
percent.
    Mr. Loudermilk. Okay. Thank you.
    Are leveraged loans made to a wide variety of businesses?
    Mr. Nini. A very wide variety. They span a lot of 
industries, a lot of different firm sizes, public and private 
firms, lots of different geographies, a very wide range.
    Mr. Loudermilk. Does that help reduce the risk of leveraged 
loans, when you have a large diversity?
    Mr. Nini. Yes, of course. It is the first thing we teach 
students of finance, the benefits of diversification.
    Mr. Loudermilk. Okay.
    Approximately what percentage of American businesses are 
considered to have a credit rating below investment-grade?
    Mr. Nini. I believe the number of firms that would qualify 
as leveraged borrowers is in the neighborhood of 70 percent to 
three-quarters. Most firms do not have a credit rating, so that 
is what makes it a little difficult to identify what exactly is 
a leveraged borrower. But I think the number, ballpark, is 
about 70, 75 percent would be considered a leveraged borrower.
    Mr. Loudermilk. Okay.
    I yield back.
    Chairman Meeks. The gentleman yields back.
    I now recognize the gentleman from North Carolina, Mr. 
Budd, for 5 minutes.
    Mr. Budd. Thank you, Mr. Chairman.
    And I want to thank our witnesses for joining us this 
afternoon.
    I appreciate the intent of the hearing, and I believe my 
colleagues are actually very sincere in wanting to spot the 
next potential crisis in our financial markets and that they 
want to prevent it as much as I do. However, I would urge 
caution that leveraged lending will be the initiation and the 
beginning of the next financial crisis.
    With my colleagues, I also appreciate all the questions 
that they raised, especially Mr. Tipton's, when it came to the 
countercyclical capital buffer. I think he actually covered 
most of my questions, Mr. Tipton from Colorado did. But I would 
like to yield some additional time to Mr. Barr, my friend and 
colleague from Kentucky.
    Mr. Barr. Thank you, Mr. Budd.
    My friend from Georgia asked, I think, an important 
question to Mr. Nini about the relative size of the U.S. 
leveraged loan market compared to the investment-grade bond 
market, the mortgage debt market, the overall fixed-income 
market.
    And the numbers, just to share for the record, according to 
the securities industry, is that, as you said, $1.7 trillion, 
$1.8 trillion is the leveraged loans outstanding today. My 
understanding is that the entire U.S. fixed-income market is 
around $42 trillion.
    So, in terms of the relative size compared to the overall 
fixed-income market, I think that is an important contextual 
fact that we need to keep in mind.
    Another point is that, in the last quarter of 2018, the 
FAANG stocks, five stocks--Facebook, Apple, Amazon, Netflix, 
and Google--during the volatility of December lost over $630 
billion in market cap, which obviously led to short-term losses 
and significant losses for their investors, but it did not 
spread across the entire financial system. And I think it is 
important to note that the losses in these 5 stocks in that one 
quarter amounts to more than 60 percent of the entire leveraged 
loan market.
    So, look, I don't think anybody is going to deny that there 
is risk in leveraged lending. Of course, there is risk in 
leveraged lending. That is the whole point. And I don't think 
many people are going to deny that credit risk is actually 
increasing either. I think the issue here, for the purposes of 
this hearing, is whether or not that increased risk presents a 
systemic issue.
    And the point is, it is just not that significant of a--it 
is an important part of the financing of great American job-
producing companies. It creates dynamism in our economy. It 
creates wages and jobs. It forestalls bankruptcies. It helps 
create efficiencies. But it is a relatively small slice of the 
entire U.S. economy from a systemic risk standpoint. I think 
that is the important point.
    Final point/question to anyone who wants to answer this, I 
have to note and observe that many of our colleagues who are 
expressing skepticism of leveraged lending here today are the 
very same Members of Congress who are calling for a rollback of 
tax reform, corporate tax reform. They are the same colleagues 
who are calling for a rollback of the limitations on corporate 
interest deductibility. They are the same Members of Congress 
who are calling for an increase in corporate income tax rates, 
which for leveraged-but-profitable companies doesn't seem to be 
like a very good idea for financial stability.
    I do not understand why we would be--if we are concerned 
about leveraged companies, why we would want to go back to the 
old Tax Code that incentivized less profit and more leverage. 
And I would be happy to invite anyone to comment on that.
    Professor Gerding, I think you want to speak to that?
    Mr. Gerding. The interest deduction for debt actually 
incentivizes more leverage by companies, both financial 
institutions and non-financial institutions. So I don't see 
that position as inconsistent at all.
    Mr. Barr. Here is my question. Why would we want to make it 
harder on leveraged companies by increasing their taxes, to the 
extent they have taxable liability? And I get it; some highly 
leveraged companies may not have profits. But most of these 
companies have taxable profit, corporate profit. They may be 
leveraged, but they have--why would we want to increase taxes--
if we are concerned about leverage in the system, why would we 
want to make it harder on leveraged companies?
    Mr. Gerding. Because, long term, I think we should be 
reducing our dependence on debt. There are other capital 
markets, like equity markets, that companies can access to fund 
themselves. Long-term, excessive reliance on debt, particularly 
debt like financial institutions, is destabilizing.
    Mr. Barr. Well, making it harder--
    Chairman Meeks. The gentleman's time has expired.
    Mr. Barr. I yield back.
    Chairman Meeks. The gentlewoman from New York, Ms. Ocasio-
Cortez, is now recognized for 5 minutes.
    Ms. Ocasio-Cortez. Thank you, Mr. Chairman.
    In 2005, Bain Capital, Kohlberg Kravis Roberts, and Vornado 
Realty Trust acquired Toys ``R'' Us in a leveraged buyout and 
saddled it with billions of dollars in debt before liquidating 
the chain in June 2018.
    They liquidated it, owing more than 30,000 workers, many of 
them my own constituents, a total of $75 million in severance 
pay while executives walked away with millions of dollars in 
the business. This was part of a leveraged buyout, or, rather, 
a leveraged lending scheme.
    Mr. Gerding, while there is no standard definition of 
``leveraged lending,'' would you say that it is thought to be 
the practice of investors or banks giving loans to companies 
that have a lot of debt on their books or companies with poor 
credit ratings?
    Mr. Gerding. Yes. The borrowers tend to be highly indebted 
and higher-risk.
    Ms. Ocasio-Cortez. So it is kind of like subprime lending 
but for corporations.
    Mr. Gerding. It is extremely--it is high credit risk.
    Ms. Ocasio-Cortez. Let's break this down. I am going to 
bust out my ``bad guy'' example. So let's say I am a bad guy, 
but this time, instead of trying to hack our political system, 
I am trying to hack our system of lending and our economic 
system of debt, you know, give me a monocle and a top hat and a 
cigar and that whole thing.
    So I am a bank, I am a bank lender. And Company ``X'' walks 
through the door. Let's call it ``Schmears.'' And they are 
asking for a loan. They have very high levels of debt and a 
poor credit rating, and by every safety and soundness example 
and measure used to assess creditworthiness, they should not 
receive this loan.
    In a leveraged lending situation, do I turn them away?
    Mr. Gerding. If you are the person that you describe, I 
think you are probably less interested in social considerations 
and more interested in just earning a profit.
    Ms. Ocasio-Cortez. Right, I just want to shoot up profit 
margin. I don't care how many people I fire. It could be 
250,000 people, which is how many were fired in the Sears 
leveraged lending situation alone.
    So, considering this Company ``X'', this company's poor 
creditworthiness, do I do my due diligence as a bank and impose 
protections for the loan that I give to them?
    Mr. Gerding. You would do your due diligence, unless you 
are offloading a lot of that risk to someone else, in which 
case you don't care as much about the risk that you are taking 
on.
    Ms. Ocasio-Cortez. And even if I do try to be a good person 
and deny them a loan, they can go down the street and get a 
loan from another bank or non-bank due to their poor credit 
rating, correct?
    Mr. Gerding. That is correct in that second part of the 
explanation for why we see so many covenant-lite loans now. And 
the chances to remain competitive as a bank, I can look the 
other way, dismiss their poor credit rating, dismiss all of 
these things, but I also don't want to take on their risk, 
right? I am lending to this terrible company that, by all 
means, could go into the ground, but if they go under, I don't 
want to be on the hook.
    Ms. Ocasio-Cortez. I can essentially pool together some 
loans in the form of collateralized loan obligations, CLOs, and 
sell it to other banks and non-banks for them to take care of, 
right?
    Mr. Gerding. That is correct. And you could even invest in 
those CLO securities yourself later on.
    Ms. Ocasio-Cortez. And when people pull those CLOs 
together, it is possible that a pension fund could buy that 
package, correct?
    Mr. Gerding. They actually do.
    Ms. Ocasio-Cortez. So teachers, police officers, 
firefighters, nurses, anyone who has a pension fund, they are 
now exposed to the risk of someone else's fat-cat gambling in 
the economy, correct?
    Mr. Gerding. Right. And they can actually purchase 
riskier--they can and do purchase riskier securities than banks 
do. So, they may be actually more exposed.
    Ms. Ocasio-Cortez. Now we are talking about, for example, 
in the case of Sears, they take on this leveraged lending, a 
CEO gets put in, runs it into the ground, fires a quarter-
million people. They sell the debt to somebody else. A 
teachers' pension fund is on the hook more than the initial 
bank that gambled it.
    Now you have fired a quarter-million people, and now it is 
teachers and their pension funds that are on the hook for 
paying for that even though they had nothing to do with it?
    Mr. Gerding. That is a valid concern.
    Ms. Ocasio-Cortez. How is this not extremely similar to the 
2008 financial crisis and the mortgage crisis?
    Mr. Gerding. I think there are important similarities.
    One similarity that hasn't been discussed is that the CLO 
securities, the pool of securities that you are describing, 
there is not an active pricing system for those. So if we are 
talking about having information about how much risk is in the 
system, market prices are, most economists would say, the best 
measure of measuring risk.
    If these giant pools do not trade on deep and liquid 
markets, we don't have the price to know exactly how much risk 
is in each of those tranches of CLO securities, including the 
tranches that you are talking about that are invested in by 
pension funds.
    Ms. Ocasio-Cortez. Thank you so much, Mr. Gerding.
    I yield my time to the Chair.
    Chairman Meeks. Thank you.
    The gentlelady's time has expired.
    And seeing no further witnesses, I now yield 2 minutes to 
the ranking member for purposes of a closing statement.
    Mr. Luetkemeyer?
    Mr. Luetkemeyer. Thank you, Mr. Chairman. I appreciate the 
opportunity to wrap up here.
    Just some closing thoughts. Today, we needed to, and we 
did, I think, find out a lot of information with regards to 
understanding leveraged loans. It is a tool that is used by 
corporations to be able to find different ways of accessing 
funds other than going to the equity markets. But, as we heard 
today, the equity market is a fallback position in case of a 
downturn. The ability to refinance is there.
    I think what we have seen is that there is not a 
concentration of credit in these, so that we have considerable 
differences between this and 2008, when we had a huge 
concentration of credit in the real estate market and the 
development market, which is considerably larger and much more 
concentrated. And it was in banks in a way that was way more 
impactful to their capital than what this would be, from the 
standpoint of the amount of that.
    And, to me, that goes back to your regulators. I asked the 
question a number of times of whether we need to have more 
regulation or more legislation. I never got an answer to the 
more legislation.
    I think, to me, we in Congress need to provide more 
oversight and not necessarily legislation. I think the 
regulators need to do a better job. To my mind, they didn't do 
a very good job in the last crisis. They need to be watching 
this like a hawk.
    But I don't know that there is a whole lot of extra risk 
here compared to what it was in 2008 based on what we have 
heard today. Interest rates, to me, are always a telltale of 
what is happening in the market, and, actually, mortgage rates 
went down last week. So I think we are probably in a better 
spot that we actually were.
    Interesting, the last conversation was somebody who 
actually, instead of worrying about jobs, that she is worried 
about a leveraged buyout or leveraged loan default, and 
actually ran off a 25,000-job business from her own district.
    But I think, to go back to this hearing, it was about 
leveraged loans. Are they systemic? Can they cause our economy 
to go over a cliff? And I don't think we have found today that 
that was the case. I think we have found that, yes, there is 
risk, but I don't know that there is a risk significant 
enough--and, as Mr. Vasisht said, there is not enough data to 
show that it is--that I think we need to be concerned about it 
from the standpoint of systemic.
    That being said, the regulators need to be doing their job. 
And if they do it, I think we will be protected.
    With that, I yield back. Thank you, Mr. Chairman.
    Chairman Meeks. Thank you.
    First, without objection, I would like to submit for the 
record an article by Mr. Bradley Keoun; a statement from 
Americans for Financial Reform; and a statement from Public 
Citizen.
    I now recognize myself for 2 minutes for purposes of a 
closing statement.
    I first would like to thank our witnesses for their 
contribution to this important conversation. I believe that 
what we heard today was genuine interest in understanding the 
nature and drivers of systemic risk and having some level of 
comfort that the regulators tasked with monitoring risks to the 
system as a whole are staying ahead of the potential emerging 
risk in leveraged lending.
    I, too, was worried when I saw what took place with 
reference to Toys ``R'' Us and Sears, and it just rang a bell 
in my ear and a ping in my stomach.
    Current and past regulators and Treasury Secretaries have 
been vocal that the integrity of the updated regulatory 
framework implemented under Dodd-Frank is key to ensuring the 
stability of our financial system and capital markets.
    We cannot forget the depth of the 2008 crisis. It is the 
worst time, or one of the worst times, I have had as a Member 
of Congress. And we must not be limited to fighting the last 
battle. Markets change and risk evolves, and regulators must 
remain vigilant as it is related to systemic risks.
    The regulators, and the Administration more generally, owe 
it to the American people and to the taxpayers to ensure that 
all available tools and resources are used to monitor, 
quantify, qualify, and map risk to the system.
    All we want, ultimately, is that when we ask regulators 
whether leveraged loans or any other risk is a systemic risk 
that they not answer, ``We don't think so,'' but they say, ``We 
are certain it is not, because we have all the data that we 
need to understand the risks, where they lie, how they flow 
across institutions, and we know how to contain it if a crisis 
were to emerge in this or another important asset class.''
    We look forward to continuing this conversation here in 
this committee and with the administration and with FSOC.
    With that, I want to thank Ranking Member Luetkemeyer and 
the other members of this subcommittee for a constructive 
discussion today. I also want to thank our witnesses for their 
testimony today.
    The Chair notes that some Members may have additional 
questions for this panel, which they may wish to submit in 
writing. Without objection, the hearing record will remain open 
for 5 legislative days for Members to submit written questions 
to these witnesses and to place their responses in the record. 
Also, without objection, Members will have 5 legislative days 
to submit extraneous materials to the Chair for inclusion in 
the record.
    This hearing is now adjourned.
    [Whereupon, at 4:28 p.m., the hearing was adjourned.]

                            A P P E N D I X



                              June 4, 2019

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