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Opinion: Wary of CLOs? Global regulator makes it worse

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Leveraged loans are risky. So, too, are the lowest-rated parts of collateralized loan obligations, which bundle together the speculative-grade loans. That assessment is hardly controversial: It’s simply what the credit grades indicate.

Rather, tensions tend to flare up when describing just how risky leveraged loans and CLOs are for the financial system as a whole. The way many market insiders tell it, leveraged loans are sufficiently spread across institutions with various objectives and mandates.

To them, CLOs, which own about half the market, are a stabilizing force because they don’t experience outflows from skittish investors. On the other side, the boom in leveraged lending is an easy target for anyone looking to make an early call on the origins of the next financial crisis. Somewhat dicey borrowers, looser lending standards and debt pooled into investment vehicles owned across Wall Street? Check, check and check.

For these reasons, investors and analysts were eager to read the Financial Stability Board’s report on the market, titled “Vulnerabilities associated with leveraged loans and collateralised loan obligations.” After all, if any group could set the record straight, it would be the FSB, a global regulatory organization that brings central banks, finance ministries, international bodies and regulatory authorities from around the world under one umbrella.

The report, which was released on Thursday, falls short of any lofty expectations. If anything, it may only amplify the paranoia around the asset class. The top-line takeaway is that the boom in leveraged lending, a market that by some estimates has swelled to $3.2 trillion in size, poses a potentially serious risk to the financial system in a worst-case scenario. But there’s virtually no way to quantify that threat.

Consider these two passages, for instance. The first concentrates on banks, the second on other investors:

“Stress tests suggest that these banks’ credit risk exposures are manageable and that banks would be able to withstand material losses on their loan portfolios, even when loans include fewer creditor protections. However there are inherent difficulties in modelling what the impact of a severe yet plausible scenario could be on complex debt products that have been originated under loose credit conditions. Furthermore, the cross-border dimension of the risks may not be fully covered by the stress tests, as interconnectedness is challenging to assess for individual jurisdictions.

Anecdotal evidence suggests that pension funds, hedge funds, private debt funds, family offices and sovereign wealth funds are among the buyers of the riskier mezzanine and equity tranches, although this has not been confirmed with data. The identities, and the capacity of these entities to withstand market volatility and losses, remains unknown. A comprehensive analysis of the vulnerabilities related to leveraged loans and CLOs would require further information on these entities’ exposures.

This does not exude confidence from the FSB that it has a firm grasp on the risks embedded in leveraged lending. The stress tests indicate that the banking system can handle a significant crack in the leveraged-loan market — but don’t take those evaluations as gospel. Hedge funds and family offices are probably the ones holding the CLO tranches that will suffer the first losses in a downturn — but there’s no hard data to support that assertion.

To the FSB’s credit, the report succinctly breaks down who owns what in the vast majority of the market. About 79% of leveraged loans and 63% of CLOs are held by banks, investment funds and insurance companies. Add in pension funds and other U.S. financial and nonfinancial organizations, and that represents 85% of the total CLO exposure. That’s useful to know, if not entirely new.

Perhaps the most eye-catching data point is the banks’ exposure to leveraged loans and CLOs relative to their capital adequacy ratios. According to the FSB, for global systemically important banks in major jurisdictions, the average ratio of that exposure to common equity tier 1 is about 60%. That certainly seems high. Fitch Ratings, in an August report cited by the FSB, estimated that the banks most active in the leveraged-loan market have direct loan and CLO exposures of about 30% to 40% of capital.

Either way, the report concludes that banks have the largest direct exposure to leveraged loans and CLOs, and, moreover, that’s “highly concentrated in a limited number of global systemically important banks.” Then there’s indirect exposure — leveraged-loan pipelines ($102 billion), funding to CLO sponsors through warehousing facilities ($28 billion) and credit facilities to intermediaries that invest in the market. “The opacity of information about these activities can limit the ability to understand the potential risk to banks of these linkages,” the FSB concluded. It plans to continue to analyze the financial-stability risks of leveraged lending and will seek to close data gaps where possible.

In general, I tend to side with those who are relatively sanguine about the dangers of leveraged lending. As I wrote last month, there’s a big difference between weaker loan covenants and some of the outright fraud perpetuated during the subprime mortgage crisis. Yes, it’s worth monitoring some trends that echo the worst behavior of the financial crisis, like CLO “combo notes,” which blend rated CLO tranches with unrated equity into newly rated debt. Individual investors aren’t clamoring for those securities, though. They’ve stampeded out of the market, with U.S. leveraged-loan funds experiencing outflows in 55 of the last 56 weeks.

Still, it would be reassuring to see a sign that those at the highest levels know exactly what’s going on. The FSB’s update was certainly welcome, but also incomplete. The opacity is unnerving. – Brian Chappatta

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