No, CLOs will not cause the next banking crisis

Collateralized loan obligations comprise less than 1% of all banks' securities, but these minor bank holdings received temporary fame recently when investors used an article in The Atlantic as further evidence of a need to sell bank stocks.

We disagree with the central point in the article that indicates the U.S. banking system has a near-term issue with CLOs.

Just 137 out of 5,276 institutions insured by the Federal Deposit Insurance Corp. hold CLOs, which are technically called “structured financial products” on call reports.

Overall banks’ securities totalled $4.3 trillion as of the first quarter, according to FDIC data. In addition, there was cash of $2.4 trillion held on all banks’ balance sheets.

CLOs amounted to $104 billion at all FDIC-insured banks in the U.S. as of March 31.

Moreover, aggregate securities and cash have increased by more $3 trillion from the fourth quarter of 2010 to the first quarter this year (overwhelming the modest $72 billion growth in CLOs at all FDIC banks). We see risk to CLOs as immaterial to regulated banks given the limited size outlined in a recent Janney report.

It’s true that certain leverage loans may default, or experience modifications and forbearance today, and then default later in 2020. But remember that CLOs are not static, the managers who created these securities could swap out loans when or if a default occurs.

Also, most banks that hold CLOs tend to have AAA-rated and AA-rated issues.

The pricing on CLOs faced temporary illiquidity during the March swoon in global financial markets, which led to weak prices for mark-to-market purposes at March 31.

However, in the past 10 weeks CLO prices have improved significantly. Banks holding CLOs are likely to experience stronger securities prices and reduced unrealized losses. This in turn translates to higher tangible book value.

Editor's note: This article originally appeared, in slightly different form, in an analyst note to Janney Montgomery Scott clients.