Banks are expected to start buying riskier portions of collateralized loan obligations (CLOs) in response to a deposit-insurance rule change that takes effect this month.
Assets now factor heavily into calculations of deposit-insurance premiums, and banks will likely seek more return to offset higher assessments stemming from even the least risky CLO tranches.
“Since this rule does not give any credit to the enhancement of the CLO triple-A tranches, it is conceivable that some bank investors will consider investing in double-A tranches to offset the higher [Federal Deposit Insurance Corp.] assessments,” Morgan Stanley Managing Director Vishwanth Tirupattur and Associate Mia Qian wrote in a March 11 report.
The FDIC changed its definitions of certain higher-risk assets in February 2011 when it revamped its system for calculating the deposit insurance premiums banks must pay the agency. The rule applied to banks with assets of $10 billion or more. It matters now because the new definitions apply to loans and CLOs issued on or after April 1. Those issued before that date are grandfathered.
No Credit for Enhancement
Assessment rates used to be multiplied by a bank’s total domestic deposits. However, the Dodd-Frank Act required the FDIC to change that basis to assets minus capital—essentially, a bank’s liabilities. The FDIC rule also adopted a “scorecard methodology” to determine the assessment rates it would charge big and highly complex depository institutions.
Morgan Stanley explained that, under the scorecard, a 50% weight in the computation is applied to “the ability to withstand asset-related stress” and 35% of the 50% weight is applied to the “concentration measure,” which measures the ratio of a bank’s higher-risk assets to Tier 1 capital and reserves.
The change in the definition of higher-risk assets to specifically include leveraged loans has affected the calculations for the “concentration measure,” possibly increasing the costs of these assessments.
The rule’s definition of a “higher-risk loan or security” covers most leveraged loans, which make up most of the collateral backing CLOs. There are three tests used to determine a “higher-risk loan or security,” according to the report.
There is a purpose test, which applies to loans that finance a buyout, acquisition or capital distribution; a materiality test, which applies to debt equal to or is more than 20% of the borrower’s funded debt; and a leverage test, which applies when the ratio of a borrower’s total debt to its trailing, 12-month earnings before interest, taxes, depreciation [Ebitda] is more than 4.0, or when the ratio of the borrower’s senior debt to its trailing, 12-month Ebitda is more than 3.0.
Under the FDIC rule, securitizations should be reported as “higher-risk assets” where 50% of the assets backing the deal meet the criteria for higher-risk loans, Morgan Stanley said. CLOs, since they are securitizations of leveraged loans, are deemed “higher-risk assets.”
Morgan Stanley isn’t alone in its view. In a March 8 note, Dechert LLP Counsel Gordon Miller said that “classifying a CLO securitization as higher-risk and treating higher-risk securitizations as a separate category will tend to increase the amount of higher-risk assets by treating an entire securitization as higher risk.”
Under the previous FDIC rule, “the classification of a highly leveraged CLO securitization as higher risk was not addressed, and a bank would look to the regulatory guidelines,” Miller said.
While holding a securitization that has a higher-risk status can potentially raise the FDIC assessments, the calculations are highly complex. “There is no one-to-one correlation between higher-risk status and the payment of higher assessments, based on the numerous steps involved and other factors considered,” he said.
“The key takeaway is that the formula is very complex and includes a number of different variables that are unique to each individual institution and something that treasury and regulatory groups within the institution will have to assess,” John Timperio, a Dechert partner, said in a telephone interview.
“Notwithstanding the complexity and uncertainty, what we have witnessed is a bit of a knee-jerk reaction from some bank purchasers of CLO notes, where they see the potential need to cover for the increased assessment through increased pricing, although it is still unclear what the actual increase would be,” Timperio said.
While Dechert is still analyzing the impact and consulting with the FDIC, Timperio said the effect of the changes on the assessment seems marginal, at best. “From an actual assessment standpoint, this seems to be a bit of a tempest in a teapot,” he said.