Former Fed Chair Janet Yellen and other big names in the financial regulatory space are expressing concern over the systemic risk of leveraged loans.

Lenders will originate leveraged loans to companies looking to finance large transactions, such as a merger. Those lenders then bundle those loans into collateralized loan obligations, which are shopped and traded among investors as securities.

Yellen recently told the Financial Times that she has seen a “huge deterioration” in lending standards in the $1.3 trillion market for leveraged loans, which has only expanded since the financial crisis.

“If we have a downturn in the economy, there are a lot of firms that will go bankrupt, I think, because of this debt,” Yellen said. “It would probably worsen a downturn.”

Yellen is not alone in flagging the leveraged loan market. In a September 2018 paper, the Bank for International Settlements published a report warning that as monetary policy normalizes, floating rates on leveraged loans could worsen borrowers’ debt coverage ratios and decrease the amount of loan recovery rates in the event of a downturn.

Collateralized loan obligations, once seen as an attractive source of yield in a low-rate environment, have also seen their spreads tighten as the Fed steadily raises rates.

An August report from Moody’s said that leveraged finance is also suffering from deteriorating credit quality. Moody’s added that leveraged loan recoveries would likely fall to 61% during the next downturn, compared to the average recovery rate of 77%, citing a growth in the number of lower-rated borrowers and changing preferences for leveraged loans over high-yield bonds.

“This structural convergence between bonds and loans will have negative consequences for investors, including worse recoveries, when the markets turn,” Moody’s wrote.

Worse recoveries = systemic risk?

The Loan Syndications and Trading Association, an advocate group for leveraged loans, points out that collateralized loan obligations rated AA-rated or better have never defaulted, even during the crisis.

“People are jumping to conclusions by focusing on credit risk but not looking at much lower systemic risk, which does not support those conclusions,” Elliot Ganz, general counsel of the LSTA, told Yahoo Finance.

And even though the securitized structure for leveraged lending resembles the mortgage-backed securities model that contributed to the 2008 crisis, collateralized loan obligations and their underlying leveraged loans are high-risk by nature, meaning that investors are generally aware of the default risk they are signing up for.