As leverage on U.S. corporate loans creeps above pre-crisis peaks and investor protections on those credits increasingly vanish, Washington continues to take notice, inquiring whether such developments pose risk to the banking system and to broader financial stability.
"The share of newly issued large loans to corporations with high leverage now exceeds previous peak levels observed in 2007 and 2014," Lael Brainard, chair of the Committee on Financial Stability for the Federal Reserve Board of Governors, said Dec. 7 at the Peterson Institute for International Economics.
Brainard also revealed data during her presentation, collected by the Fed, detailing how the largest U.S. banks collectively own some $90 billion in collateralized loan obligations.
Those banks — which include JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. — are concentrated primarily in the senior tranches of CLOs. Banks made up 59% of the buyers for AAA tranches of CLOs, 6% of AA tranches, 6% of A tranches and 1% of the equity tranches this year, according to Deutsche Bank.
Banks abroad have also been active buyers of the senior-most collateralized loan obligations tranches. A few weeks prior, Japanese agricultural cooperative bank Norinchukin Bank said its total holdings of AAA CLO paper in both the U.S. and Europe rose to $51 billion, a $17 billion increase over the first half of this year.
Brainard also cited the increasing use of EBITDA add-backs, growth of covenant-lite loans and the ability to tack on incremental pari passu debt as areas warranting further scrutiny.
Brainard was just the most recent voice in a growing chorus of current and former policymakers — including former Fed Chairman Janet Yellen, the Bank of England, the Office of the Comptroller of the Currency and the Bank of International Settlements — to raise warnings about the sector.
"Previously, much of this deterioration in underwriting appeared to be concentrated among nonbank lenders, but this year has witnessed a deterioration in underwriting at the largest banks," Brainard said, also suggesting that a "heightened focus on industry risk-management practices was warranted."
Her comments follow those of Randal Quarles, vice chair for supervision at the Federal Reserve Board of Governors, who said Dec. 3 at the Council on Foreign Relations that the Fed is monitoring potential "back-door" risks to banks via their holdings of CLOs. Those CLOs comprise 60% to 65% of the purchases of U.S. leveraged loans, according to LCD.
Still, while Quarles acknowledged in his remarks the rapid growth of the leveraged loan market and eroding underwriting standards, he was relatively sanguine regarding the asset class, due to the stable funding structures of CLOs.
"So then the second question is ... if there were an event that resulted in a lot of those loans creating losses, are the holding structures likely to amplify financial instability?" Quarles said in his remarks.
That CLOs are often issued with a relatively lengthy maturity of 11 to 13 years, compared to bank or repo lines, and that they are "not runnable" offered comfort to Quarles. However, in response to a question at the event, Quarles did note that the Fed is monitoring potential risks in mutual funds and exchange-traded funds regarding any funding mismatches.
Retail funds and ETFs, which in some cases offer daily redemptions (versus loans, which can be illiquid), make up 16% of the leveraged loan investor base, according to Bank of America Merrill Lynch. This compares to the high-yield bond market, where they make up a larger percentage, closer to 40%.
Limited CLO losses
Regulators may at least be able to take comfort in the fact that CLOs have historically weathered principal losses well.
Of the 4,322 CLO tranches that were rated by S&P Global Ratings before 2008, only 38 tranches across 22 CLOs have defaulted, with the defaults primarily concentrated in the BB tranches. Only one AA tranche has defaulted, while none rated AAA have defaulted.
"Unlike CDOs and CDO-squareds and so forth, the CLO structures were not particular contributors to the last crisis, which doesn't mean that ... they can't be in the next crisis," Quarles said. "But at least the best information that we have is that they're not evolving in a way that would be a particular problem."
However, investors may show mark-to-market losses if volatility continues. As a number of more bearish investors point out, the fact that covenant-lite structures have yet to be tested in a downturn raises questions over just how much less loans might recover following a default, compared to their historical rates. You can see S&P Global's analysis on this issue, courtesy of LossStats, here.
The CCyB debate, continued
Brainard has been one of the Fed's strongest advocates for what is known as a countercyclical capital buffer, or CCyB, finalized in September 2016, which would raise capital requirements for the largest U.S. banks to provide a sustainable source of credit for when losses rise above historical levels. On Dec. 7, she reiterated her calls for the banks to increase their buffers.
That buffer, which remains at zero, is decided by the Board of Governors once a year and recently has received support from others, including Minneapolis Fed President Neel Kashkari, Boston Fed President Eric Rosengren and Cleveland Fed President Loretta Mester. The CCyB range can be between zero percent and 2.5% of additional common equity Tier 1 capital, or CET1 capital.
Under Basel III, a bank's minimum common equity Tier 1 capital of its risk-weighted assets must be 7% in 2019. At the end of the third quarter, the CET1 capital of JPMorgan, Bank of America, Citigroup and Wells Fargo was 11.97%, 11.42%, 11.73% and 11.91%, respectively.
But not everyone at the Fed is universally in support of raising the CCyB.
"Those who are currently saying we need to turn on the countercyclical capital buffer aren't really articulating that call in terms of a change in framework," Quarles noted. "They're simply saying, 'Why wouldn't we turn this on?' We have a framework for evaluating when we turn it on. And that framework currently says we should not."