Banks Are The Largest Holders Worldwide Of Leveraged Loans And Collateralized Loan Obligations

Bank of England research shows that the share of corporate debt owed by highly leveraged companies across major advanced economies is now similar to, or higher than, levels  in 2007. The reason that this should worry us is that “cross-country data shows that growth in the corporate debt to GDP ratio is associated with deeper recessions.”

The Bank of England’s recently published Financial Stability Report shows that banks, especially American ones, are the largest owners of leveraged loans and collateralized loan obligations (CLOs).   Banks own a little over 55% of the $3.2 trillion global leveraged loan and CLO market.  Banks own leveraged loans in three ways: they hold some on their balance sheets, they have them in the pipeline to sell to a special purpose vehicle which will then sell the leveraged loans in a CLO, and by holding CLOs.

Sources: Association for Financial Markets in Europe (AFME), Bloomberg Finance L.P., European Central Bank (ECB), FCA Alternative Investment Fund Managers Directive (AIFMD), LCD, an offering of S&P Global Market Intelligence, Morningstar, National Association of Insurance Commissioners (NAIC), Securities and Exchange Commission (SEC), Securities Industry and Financial Markets Association (SIFMA), asset management public disclosures, bank public disclosures, pension fund public disclosures, private supervisory data, Solvency II submissions and Bank calculations.

(a) One square = 1% of US$3.2 trillion global leveraged lending market, data as of end-2018.

(b) Estimates of the total stock are based on Bloomberg’s definition of leveraged loans. Given the lack of a consistent definition of leveraged lending, there is uncertainty over the total stock of outstanding leveraged loans. This chart uses a broadly defined market, which includes revolving credit facilities, amortizing term loans and smaller less liquid bullet term loans.

(c) Revolving credit facilities and amortizing term loans are allocated to banks given that they are typically the holders of these facilities.

(d) Complete data are not available for some non-banks, and so values have been estimated based on partial data. The grey segment marks the areas of most uncertainty.

(e) For hedge fund holdings of leveraged loans and CLOs we scale up holdings reported to

UK authorities by non-EEA managed alternative investment funds to reflect the size of the global hedge fund universe. This means these estimates are particularly uncertain.

(f) A separately managed account (SMA) is a product offered by asset managers to large institutional clients like pension funds and insurers for example.

(g) Data for insurers largely refers to US entities. A proportion of holdings are through products that are offered by insurers to outside investors.

(h) Pipeline exposures held by banks are not included.

The largest bank holder of CLOs is Japanese bank, Norinchukin ($68 bn), which is about 10% of the U.S. CLO market. Andrew Park, of LCD News, recently wrote that “Norinchukin’s actions are closely scrutinized because its investment decisions can have an impact on the AAA tranches, which are the greatest piece of a CLO’s financing costs (nearly 60%). Changes to a CLO’s financing costs could also affect loan spreads, as CLO managers seek to capture a certain level of arbitrage between the liabilities and the underlying loan assets.”

Norinchukin holds more CLOs than any U.S. bank. According to S&P Global Market Intelligence data, Wells Fargo($36bn), JPMorgan ($24bn), and Citibank ($21bn) are the largest bank holders in the U.S.  Reportedly, Wells Fargo and Citibank have increased their holdings in the second quarter of 2019 from the first quarter.  Their full second quarter balance sheets, which should be released shortly, will provide more recent detail.  According to Park, Deutsche Bank has been buying CLOs.  I find this very strange since the market illiquidity of CLOs consumes more capital under new market risk rules. Now is precisely the time that Deutsche Bank should be better capitalized to sustain unexpected losses.

About 40% of leveraged loans and CLOs are owned by non-banks such as asset managers, private equity, hedge funds, and business development companies (BDCs). As I have argued in over 20 Forbes publications about leveraged lending and CLOs, banks and non-banks are very interconnected, particularly since banks provide millions in loans and credit and liquidity facilities to banks. American Banker’s Andy Peters recently wrote that bank lending to non-banks in the U.S. is rising; hence the interconnections between them is rising.  Moreover, banks are interconnected to non-banks through investing in non-bank debt and equities, as well as being counterparties to non-banks in derivatives and repurchase agreements.

Banks and non-banks continue to come up with different types of CLOs. This reminds me of 2006-2007 when banks were creating all kinds of very illiquid and risky collateralized debt obligations such as structured finance CDOs, CDO2 and even CDO3.  A couple of months ago CLO managers started creating what they call ‘enhanced CLOs,’ because naming them ‘Gasping for Air At The End of The Credit Cycle,’ would probably not make these products as marketable.

Why do leveraged loans and CLOs matter?  Numerous macroeconomic and market signals point to a slowdown.  If the Federal Reserve cuts rates in this month of in the near future, lower rates will further fuel demand for higher yielding instruments such as leveraged loans and CLOs. Other central banks around the world are already cutting rates or are in the process of doing so.

A number of analysts, legislators and regulators have pointed out that CLOs performed well in the last crisis. Yes, but back then the catalyst for the crisis were residential mortgages. It is now companies which are very indebted, in notional numbers and as a percent equivalent of GDP. Many of these are zombie companies that have been borrowing to pay existing debt, pay dividends, engage in share buy backs, and/or to pay executives bigger bonuses. As we get into an economic downturn, there is a high risk that leveraged companies will default on their obligations and fire employees in an attempt to stay afloat.

Presently, 80-85% of leveraged loans have lite or no covenants. When companies default, lenders will have very little in protection. They will have to increase capital for non-performing loans. In 2007, a little under 30% of the loans were covenant-lite.  In 2008, the number of leveraged loans issued plummeted and the few that were issued overwhelmingly had covenants. Since 2010, the number of covenant-lite loans has grown significantly.

Since the 2008 financial crisis, Basel III credit and market risk rules have become stricter. Now, banks would have to increase capital allocations to their banking and trading books in the event that these products’ credit quality migrated downward and when they become even less liquid in trading portfolios than they are now. As banks have to increase capital in an economic downturn, not only will they want to sell leveraged loans CLOs, they might also have to sell other assets in order to meet capital regulatory buffers.

Source: Forbes.com

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