Banks are expected to start buying riskier portions of collateralized loan obligations in response to a deposit-insurance rule change that takes effect next month.
What’s the connection between two such seemingly different parts of the financial world? Assets now factor heavily into calculations of deposit-insurance premiums, and banks will 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 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 report published March 11.
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.
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, specifically 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 Morgan Stanley 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 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 actually securitizations of leveraged loans, are deemed as “higher-risk assets.”
Morgan Stanley isn’t the only firm looking at the likely impact of new deposit insurance rules on bank appetite for riskier tranches of CLOs. In a March 8 note, Dechert LLP Counsel Gordon Miller said that in introducing the 50% test “for 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, securitizations that were either 50% backed by commercial and industrial loans to borrowers considered highly-leveraged, based on Ebitda, or backed by loans designated as highly leveraged by a syndication agent, were classified as “leveraged loans” and were not treated as a separate category.
“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 having holding 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,” Miller 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.
Timperio said that it did not appear likely that the assessments for securitizations that were 50% or more backed by C&I loans classified under “leveraged loans” in the previous rule will be treated any differently under the separate category of high-risk CLO securitizations in the new rule, given that the typical CLO is usually 90%-95% backed by leveraged loans.
And Morgan Stanley said that, even considering the potential for higher assessment rates, triple-A-rated tranches of CLOs still provide attractive returns, relative to alternative investments.
Nevertheless, the possible increase in the charges is causing some bank investors to reconsider their participation in the CLO market. “The effects of the rule could limit the potential for spread tightening in the CLO AAA tranches,” Tirupattur and Qian wrote.
Timperio said that amount of assessments charged will not be affected by where in the capital structure investors choose to buy. However, investing in the lower-rated tranches can provide more yield and offset the perceived higher assessment costs but this would run counter to the FDIC’s intentions.
“The assessment is not based on the piece you buy, so it doesn’t matter where you buy in the capital structure, but hypothetically, if the assessment would cost 10 basis points more for a CLO, then it would make sense to go down the capital structure to cover that 10 basis points,” he said.
“But what we’re really seeing is a bit of a rush to get [CLO] deals done before April 1 [when the new rule takes effect], with people acting more to avoid the uncertainty than the negative impact of the assessment.”