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Is CLO market suffering from crisis fatigue?

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The Loan Syndications and Trading Association is fresh off a legal victory that exempts most CLOs from “skin in the game” rules. It was an almost eight-year battle that involved seven legal briefs and literally hundreds of meetings with members of Congress and regulators.

Yet, Elliot Ganz, the trade group’s general counsel, says the industry is now facing an even bigger challenge: The possible demise of the London interbank offered rate, the benchmark interest rate for some $4 trillion of U.S. below-investment-grade corporate loans as well as their biggest investors, the $500 million of outstanding U.S. collateralized loan obligations.

In an address at IMN’s annual CLO conference Thursday, Ganz called it “possibly the biggest challenge we've ever faced.”

Then he handed the podium over to Meredith Coffey, the LSTA’s head of research and analysis. “What I really want to do is scare you guys enough to get you engaged in the process, but not enough so that you go catatonic,” Coffey quipped.

In a nutshell, the banks that contribute quotes to produce Libor are increasingly less willing to do so; they rarely lend each other money overnight, so it’s difficult to determine at what rate they might do so. U.K. regulators have announced they will stop compelling banks to submit quotes after 2021, meaning the index might not be available after that date.

And there are big problems, at least for loans and CLOs, with the Secured Overnight Financing Rate, which is supposed to replace Libor (at least in the U.S.). It is measure of the cost of borrowing cash overnight collateralized by Treasury securities, and so does not reflect credit risk.

So unlike Libor, which tends to rise during periods of market stress, SOFR is likely to remain level, or possibly even fall, during a market dislocation.

Why does that matter?

“In periods of credit stress, you could see a situation where banks have to lend below their [funding] costs,” Coffey said. “That’s not a good business model.”

She outlined three kinds of adjustments being discussed to add an element of credit risk to SOFR, none of them ideal. One is a static spread, which has the benefit of being simple, if nothing else; the second is a “dynamic” spread that Coffey described as “very complicated” and susceptible to some of the problems with Libor itself; the third is a static spread accompanied by an additional spread in the event of a “break the glass” situation.

CLO market participants may be suffering from crisis fatigue. At the conclusion of her remarks, Coffey asked how many members of the audience were indeed “scared enough to engage in the process” of preparing for Libor’s demise. A single person raised his hand.

On the other hand, only three people could be bothered to raise their hands to indicate that they were “scared enough to go catatonic.”

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SOFR Loan Syndications & Trading Association