CLO losses experienced by non-bank investors such as hedge funds and insurance companies could present risks to banks, the BIS says in its quarterly review.
The BIS (Bank for International Settlements) in its quarterly review has highlighted the growth of CLOs (collateralised loan obligations) as a development that could give rise to financial distress.
In its quarterly review, the BIS draws a parallel between today’s CLOs and the CDOs (collateralised debt obligations) that were at the centre of the 2018 global financial crisis.
Whereas pre-crisis CDOs invested in subprime mortgage-backed securities, CLOs invest mainly in leveraged loans – bank loans to firms that are highly indebted, have high debt service costs relative to earnings, and are typically rated below investment grade.
According to the BIS, the leveraged loan market has surged in recent years to roughly USD 1.4 trillion outstanding, a “rapid expansion” that has been accompanied by the securitisation of leveraged loans into CLOs. As of June 2019, over 50% of outstanding leveraged loans in US dollars and about 60% of those in euros had been securitised through CLOs.
Compared to pre-crisis CDOs, today’s CLOs are less complex, back by more diversified pools of collateral, little used as collateral in repo transactions, less commonly funded by short-term borrowing, and less opaque about direct bank exposures.
However, similarities between the pre-crisis CDO market and today’s CLO market could give rise to financial distress, the BIS says.
These include the deteriorating credit quality of their underlying assets, the high concentration of banks’ direct holdings , the opacity of banks’ indirect exposures, and the uncertain resilience of senior tranches.
While US and Japanese banks are among the largest investors in CLOs, non-bank investors such as hedge funds and insurance companies also have significant exposures – and their ownership is more difficult to trace.
CLO losses experienced by non-bank investors present indirect exposure to banks, particularly if they are connected to the non-banks through legal and reputational ties, credit facilities or prime brokerage services.
“Like banks’ off-balance sheet exposure to CDOs, which was a source of instability in 2007, banks’ prime brokerage exposure to CLO holders could result in larger losses than implied by direct exposures, creating heightened financial stress,” the BIS says, adding that additional spillovers could arise from disruptions in market liquidity.
Some investment funds offering daily redemption hold as much as 3% of their assets in CLOs. In market distress, investors rushing to redeem their shares will quickly deplete the liquidity buffers held by such funds.
The BIS warns that such a redemption rush could result in fire sales and large price volatility, which would impose mark-to-market losses on other intermediaries and disrupt short-term funding collateralised by CLOs.
However, it notes that the use of CLOs as repo collateral “appears minimal” today, in contrast to the more widespread use of CDOs or mortgage-backed securities in the lead up to the 2008 crisis.