Banks around the world are exposed to the credit, market, operational and market liquidity risks of leveraged loans and collateralized loan obligations (CLOs). And those risks have not diminished this year. Because banks hold people’s deposits, legislators, regulators, former central bankers and consultants such as myself should continue analyzing what risks leveraged loans and CLOs pose to depository bank institutions, especially in light of an increasing array of macroeconomic indicators that show a rising number of countries’ economies that are slowing down, and which in some cases, are very close to being in a recession.
As I have explained in over 25 articles on this subject, banks have significant primary and secondary exposure to leveraged lending and CLOs. In addition to holding leveraged loans, they also are underwriters and distributors of leveraged loans. They also warehouse, arrange and invest in CLOs. Banks’ secondary exposure exists because they lend to non-banks who underwrite leveraged loans and CLOs and banks are counterparties in interest rate and credit derivatives with these non-banks. According to a report released by Fitch Ratings yesterday, presently “Exposure to potential drawdown of commitments under borrower stress should be manageable for rated banks. Spreads and underwriting standards have eroded in the late stages of the credit cycle, but commitments from banks such as revolving credit facilities are likely to have stronger borrowing base requirements, greater seniority, or less risky repayment structures than term loans typically offered to other institutional investors, though cross-default and cross-acceleration clauses exist.” However, the analysts also said that “Losses could arise from originated but not yet syndicated leveraged loans.” At that point, it is possible that banks may try to “invoke flexible terms or cut into fees to reduce losses.”
The Fitch Ratings report, “Leveraged Loans & CLOs in Financial Institutions” estimates that banks “more active in the leveraged loan market have direct loan and CLO exposures averaging around 30%-40% of capital.” Currently, European, Japanese, and US banks hold about USD250 billion of CLOs.
On the positive side, CLOs issued since the crisis have more credit protections than they did in the run up to the financial crisis. However, in an economic or market downturn, when investors become nervous, they will have a hard time selling their CLO investments given how illiquid these instruments are. This will push prices down. Most banks hold their CLOs in their trading books as available for sale. Downward prices and the illiquidity of these products would push banks to increase regulatory capital to help sustain unexpected losses in order to comply with Basel Committee on Banking Supervision international standards known as Basel III. I concur with the Fitch analysts who stated that they “believe banks are more likely to be affected by mark-to-market (MTM) losses than realized losses.” However, when rating agencies downgrade CLOs, this will also push banks to increase their regulatory capital. Fitch analysts’ view is “that any potential outsized ratings impact in a stress would most likely stem from unexpected permutations of spillover risk instead of direct exposures.” If banks cannot increase capital, this could lead to fire sales of their other assets.
In the U.S., the largest holders of leveraged loans and CLOs are Citibank, JPMorgan, and Wells Fargo. According to Fitch Ratings analysts, “in the US, banks with exposure across underwriting, nonbanking lending, securities holdings and on-balance-sheet exposure are likely to be relatively more affected by a material downturn in leveraged lending.”
The position of Europe banks is similar to the US, “with larger banks with capital markets activities generally more exposed given the various ways they are involved in the asset class.” It is important to note that European banks could “have higher exposures to non-bank participants due to the dominance of bank wholesale funding because capital market growth, such as the capital markets union initiative, remains in development.”
According to Fitch analysts, “A few Japanese banks, particularly Norinchukin (unrated), have been very active in buying CLOs. While banks are often selective with CLO managers, we believe the correlation of CLO investments means the asset class will largely move together irrespective of manager selection. Mid-sized banks are more likely to have riskier positions relative to their expertise and overall financial strength.” Of concern is that Norinchukin’s CLO holdings are “equivalent to 103% of its CET1 capital and it has accelerated its buying in the past year.” Japan Post Bank also increased its CLO purchases significantly in 2018, although its overall exposure is lower than Nornichukin’s. Japanese mostly hold their CLOs as available for sale. Hence, those banks with large CLO exposures would be adversely affected by mark-to-market losses if CLO tranches are downgraded.
It is also important to remember that in a downturn, “spillover effects are likely to be greater for banks relative to insurers given their links with non-bank participants and broader activities in the leveraged loan, CLO and credit markets.”