US banks’ exposure to CLOs decreases slightly in the first quarter
Secured loan bond holdings in U.S. banks edged down in the first quarter to just under $ 99 billion from $ 99.5 billion at the end of the fourth quarter of 2019, according to the documents. bank regulations with the Federal Reserve.
JPMorgan Chase & Co. is again the largest holder of CLO securities as of March 31, bringing its total holdings to just under $ 34 billion in the first quarter, from $ 29.8 billion at the end of 2019.
Wells Fargo & Co.’s holdings of CLO securities declined $ 4.5 billion in the quarter to $ 24.6 billion, although the bank revealed in a recent SEC filing that it had increased its holdings of CLO loans to $ 7.7 billion as at March 31, from $ 7 billion as at December 31, 2019. Combined with holdings of securities, this brings Wells’ total exposure to CLO to nearly $ 32.3 billion.
CLOs held as loans are classified differently for regulatory purposes than CLOs held as securities and are not represented as structured finance products backed by corporate loans in Y-9C deposits with the Federal Reserve.
Citigroup Inc. slightly increased its holdings by just over $ 50 million in the first quarter to $ 21.4 billion.
These three banks account for just under $ 80 billion in CLO exposure within the banking system, or 81% of the roughly $ 99 billion in CLOs held by U.S. banks. This proportion is unchanged from the end of 2019.
Do CLOs pose a systemic risk to the banking industry due to COVID-19?
In light of the global economic downturn triggered by COVID-19, economists, policymakers and investors have expressed significant concerns that high leverage among speculative-grade U.S. companies could amplify medium-sized economic pain. term that the pandemic will cause.
In particular, the large loss of revenue from COVID-19 lockdowns has made the debt burden of some companies unsustainable, resulting in a number of loan abstentions and modifications, and in more serious cases, swaps in difficulty and bankruptcy. These scenarios all involve difficulties and losses for loans in CLOs and, potentially, for banks exposed to them in securitized form.
While the default rate is expected to rise, CLO holdings on bank balance sheets appear unlikely to suffer major write-downs due to defaults – at least for now.
US banks typically hold the most senior debt in a CLO vehicle, and because the loans in a CLO portfolio experience a sufficient degree of distress, interest payments to junior debt holders are redirected to repay senior investors again. faster than is usually the case.
“The risk to AAA CLO holdings, which are primarily held by banks, appears relatively low.… 58% of the underlying leveraged loans are expected to cumulatively default before seeing any capital losses,” assuming a 40% recovery rate, wrote Vivek Juneja, large-cap banking analyst at JPMorgan, in a June 24 memo. Juneja also noted that default rates would have to remain constant at 29% over the life of a CLO to see write-downs at the AAA level, also assuming a 40% recovery rate.
Fortunately, no one expects the economic downturn caused by COVID-19 to be so severe – again, it is for now. Bank tellers are forecasting a default rate for leveraged loans at just under 10% by the end of this year, while S&P Global Ratings recently forecast the speculative-grade corporate default rate on 12 months in the United States will likely drop to 12.5% by March. 2021; in a more pessimistic scenario, he predicts the default rate will drop to 15.5% “following a possible resumption of COVID-19 cases later this year or early next year … [which] could further complicate this scenario. “
Likewise, the expected recovery rates of impaired loans remain low, but not low enough to involve CLO losses at AAA level. For example, Moody’s recently lowered its recovery expectation for senior loans to 58% for companies with private equity sponsors and to 62% for those without. Although these are still significantly lower than the historical average recovery achieved of 75% and 78%, they are not so low that they imply write-downs of bank balance sheets to the AAA level, based on the previously cited forecast. a cumulative default rate of 58% with a recovery rate of 40%. Early levels may result in losses elsewhere in the CLO’s capital structure, but not likely on senior debt on bank balance sheets.
However, the macroeconomic outlook remains very uncertain. These forecasts could change in a matter of weeks, for better or for worse. Default rates and expected recoveries on bad loans are still only forecasts and may change depending on a strengthening or deteriorating economic situation. So, while CLOs are still a long way from altering bank balance sheets, it is equally true that they are much closer to doing so today than they were just three months ago.
This S&P Global Market Intelligence news article may contain information on credit ratings issued by S&P Global Ratings. Descriptions in this news article were not prepared by S&P Global Ratings.