Imagine a trillion-dollar market that runs on faxes and phone calls while routinely tying up investors’ money for months before they get any return.

An employee counts a stack of U.S. one hundred dollar bills inside a currency exchange center in Mexico City, Mexico. Photographer: Susana Gonzalez/Bloomberg
Imagine a trillion-dollar market that runs on faxes and phone calls while routinely tying up investors’ money for months before they get any return.
That’s not fiction: It’s the unregulated market for leveraged corporate loans. In a financial system that is increasingly automated, the origination and trading of loans is in the relative dark ages while money pours in from mainstream investors such as Kansas and New York pension plans and mutual funds catering to individuals seeking high yields in an era of near-zero interest rates.
The antiquated structure of a market that’s ballooned from a mere $35 billion in 1997 poses a growing threat, raising the odds of gridlock in a downturn when investors expect to get their money back with a click of a button. As of yet, no regulators have taken responsibility for fixing the deficiency.
“It’s a critical issue,” said Beth MacLean, a money manager at Newport Beach, California-based Pacific Investment Management Co., which oversees $1.97 trillion, including the world’s biggest bond mutual fund. “Any single retail fund not being able to meet their redemptions would have a ripple effect on the whole market.”
The time it takes to settle a loan has gotten worse since the financial crisis, lengthening to an average 20 days as of June, from 17.8 days in 2007, according to data tracked by the Loan Syndications and Trading Association. In the high-yield bond market, it generally takes three or fewer days.
Not Securities

When regulators were drafting securities laws more than seventy years ago, company loans were excluded because they were mainly private transactions between one bank and one borrower. That’s no longer the case, as the debt is mostly syndicated, or distributed, to investors who can then trade the loans among themselves like a bond or a stock.

Judith Burns, a spokeswoman for the U.S. Securities and Exchange Commission, which has placed a priority on monitoring corporate and municipal bond trading more closely, declined to comment. So did representatives of the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. which have all raised concern that banks are being too lax in their loan underwriting standards.
The logjam in the modern syndicated-loan market, founded in 1982 by JPMorgan Chase & Co. Vice Chairman James B. Lee Jr., matters to more people than ever.
Riskier Things

Investors poured an unprecedented $62.9 billion last year into mutual funds that buy the debt, which is mostly speculative-grade, according to Lipper data. They have been lured by yields greater than those of higher-rated securities and interest payments that float above benchmark rates with the latter being an attractive feature amid speculation the Fed may boost borrowing costs next year.
Mutual funds bought 32 percent of new loans last year, up from 15 percent in 2012, LSTA data show. The New York City Employees’ Retirement System held about $961.8 million as of March 31, regulatory filings show.


“Pension and retirement funds have poured in for the reason you know: They need yield,” said Erik Gordon, professor at the Ross School of Business at the University of Michigan in Ann Arbor. The low-rate environment has “forced people’s retirement to be invested in riskier and riskier things and this is an example of a riskier thing.”
Some of the worst delays in settlement times can be found in the market for new loans, where Pimco’s MacLean said it’s not uncommon for months to pass before a purchase is completed.
Huntsman Loan

Investors committed $1.2 billion in October to fund a loan for junk-rated Huntsman Corp. For about 10 months, they didn’t receive a dime.
Salt Lake City-based Huntsman obtained the financing to help pay for its purchase of Rockwood Holdings Inc.’s titanium dioxide business. The merger has taken longer than anticipated because of an antitrust holdup.

Kurt Ogden, a vice president of investor relations at Huntsman, said last month the loan commitment has been extended through Dec. 17. Investors were paid a fee in August, at which time the company also started putting aside interest that they’d receive upon settlement, said spokesman Brad Hart.
While the delays wouldn’t happen in a bond offering, it’s permissible in the loan market, where each financing is crafted according to individual borrowers’ desires.
One reason there’s little momentum to streamline trading is that Wall Street banks benefit from the status quo, according to Scott Page, director of bank loans at Boston-based mutual fund firm Eaton Vance Corp. Banks earn fees for committing to fund deals until they close while shifting risk to investors.
Archaic System

“The biggest banks who act as underwriters have an apparent self-interest in maintaining this archaic system,” Page said. “We are mystified by the fact they seem to have no interest in fixing it.”
JPMorgan and Bank of America Corp., the two biggest underwriters, as well as other big banks, typically earn fees of 1 percent to 5 percent for arranging a leveraged loan, according to Standard & Poor’s data. That compares with 0.5 percentage point on bonds for investment-grade companies, and 1.3 percent for junk notes last year, Bloomberg data show.

While buyers and sellers can trade stocks and bonds among themselves, they need the approval of corporate borrowers before they can exchange loans. Clerks must then update loan documents to reflect new lenders.
With loans, “there’s a high amount of faxing going on still,” said Virginie O’Shea, a senior analyst at Aite Group LLC in London. “People don’t realize that fax machines are still around in this day and age but they are.”
No Incentive

Banks have no incentive to drag out the time it takes to settle a loan, according to Bram Smith, executive director of the New York-based LSTA, the market’s main lobbying group.
“It’s a well-known fact to market participants that loan settlement is different from that of other asset classes,” he said. By recognizing the difference, both mutual funds and other investors have “prospered and grown quite nicely.”
Brian Marchiony, a spokesman for New York-based JPMorgan, and Zia Ahmed, a spokesman for Charlotte, North Carolina-based Bank of America, declined to comment.
While loans may be inefficient to process, their ability to be crafted for unique financing situations is what makes them attractive to many borrowers and lenders, the LSTA’s Smith said.
Wall Street’s biggest banks have helped speculative-grade companies including cable-television provider Charter Communications Inc. and hospital operator Community Health Systems Inc. raise $405 billion this year through loans that were distributed among investors, data compiled by Bloomberg show. That’s the fastest pace ever.
Less Liquid

“Bank loans are a popular topic these days –- a source of stable returns, less risk to rising interest rates,” Dennis MacKee, a representative of the Florida State Board of Administration, wrote in an e-mailed response to questions. “In return, there is a trade-off of some liquidity.”
The Kansas Public Employees Retirement System board of trustees agreed in May to commit $100 million to a strategy focused on high-yield bonds and leveraged loans.
The concern is that there may be a mass exodus from mutual funds that could strain the loan market as investors anticipate rising borrowing costs and defaults. Mutual funds and exchange-traded funds settle investors’ redemption requests within three to seven days, according to Moody’s Investors Service data.
“There’s kind of a liquidity mismatch,” the University of Michigan’s Gordon said. When investors try to redeem and can’t get their money back right away, more will try to pull cash, risking a run, he said.



Market Risk

The expense to investors resulting from a paper-based market’s inefficiencies stretch beyond missed payments. The market can easily turn in a month, leaving investors funding deals at yesterday’s rates.
The 1.19 percent decline in loan prices since the end of June suggests that buyers of $1 billion of loans at rates set then would be overpaying by $11.9 million if the deal closed now, based on S&P and LSTA index data.
Investors have started to push back, demanding fees on loans that fail to settle within a designated period, often a month or more, Bloomberg data show.
“The longer the wait, the greater the danger of a problem” for investors, former SEC Chairman Arthur Levitt said in a telephone interview.
Levitt, who is on the board of Bloomberg News parent Bloomberg LP, warned more than a decade ago that debt traders and bankers needed to shrink the time it took to complete trades.
Cost Cuts

The labor-intensive process of settling a loan trade requires banks to maintain teams of back-office staff at a time when they’re eliminating jobs to boost profitability.
JPMorgan charges a $3,500 fee for each trade made by investors who exchange debt it helped distribute with competing firms, people with knowledge of the matter told Bloomberg News earlier this year.
Those types of fees would decline or disappear if the debt fell under securities rules, according to Elisabeth de Fontenay, a Duke Law School professor in Durham, North Carolina, who previously worked as a corporate lawyer at Ropes & Gray LLP.
There are other costs to investors. Fund managers often pay to maintain credit lines they can draw upon to meet redemptions and hold extra cash to mitigate the risk they’ll be unable to quickly sell underlying loan holdings.
Fund Flows

“Should investor flows reverse, the mismatch in bank-loan funds could pose a material risk,” Moody’s analysts led by Stephen Tu wrote in a July 7 report.
While mutual-fund investors have started souring on the loans, pulling $4.7 billion this year, other institutions have continued to amass record amounts of money to buy the debt.
Firms from Apollo Global Management LLC to GSO Capital Partners LP raised an unprecedented $60.7 billion in the first half of 2014 for collateralized loan obligations, which pool loans and slice them into pieces of varying risk and return.
“It’s a very complex, very large challenge requiring the consensus of market participants, including, in some cases, the borrower,” LSTA representative Howard Moore said in an e-mail. “Progress has been slower than we wanted, but the LSTA and its members are committed to improving the settlement process.”
Without pressure from regulators, Wall Street’s biggest banks haven’t yet overhauled the market. They’ve been cutting hundreds of thousands of jobs to reduce costs as they face stricter regulations intended to help prevent another crisis.
“You have to believe having an archaic system break would ultimately be more expensive for everyone, including the agent banks,” Eaton Vance’s Page said. “Many people have approached them and they have no interest” in fixing the problem.


To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net
To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage

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