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The Fed puts a new spotlight on banks’ leveraged loans, CLOs
admin | February 14, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The Fed’s annual bank stress test this year puts a new spotlight on leveraged loans and CLOs by looking at their performance in a scenario with declining earnings, broad downgrades and a sharp drop in market prices. The new scrutiny could cool demand from the largest banks for CLOs until results from the 2020 tests come together, although recent proposed changes to the Volcker rule could keep bank interest steady.
The Fed will look at the performance of 34 banks in its annual DFAST and CCAR stress scenarios this year, with only 11 banks required to run the most severe stress on leveraged loans and CLOs. The tested banks together hold $68.6 billion in CLO debt, with the 11 banks subject to severe stress holding $57.3 billion (Exhibit 1).
Exhibit 1: : Eleven of the 34 largest banks are subject to a severely stressed scenario on leveraged loans and CLOs in the Fed’s stress test for 2020
Source: S&P, Amherst Pierpont Securities. Note: These numbers show total CLOs calculated as the sum of available-for-sale structured financial products backed by corporate or similar loans held at fair value and held-to-maturity structured financial products backed by corporate loans or similar loans held at cost.
The Fed will conduct its stress tests this year using two scenarios: a baseline and a severely adverse scenario. The baseline scenario assumes a moderate economic expansion over a 13-quarter period, while the severely adverse scenario marks a severe global recession followed by intense stress in the commercial real estate and corporate debt markets. Eleven of the banks must also incorporate global market shock into its severely adverse scenario, which underscores this year the stress in the leveraged loan market.
Recent stress testing of leveraged loans and CLOs by the NAIC, covered earlier by APS, suggests that most bank holdings would avoid actual losses in the Fed’s scenarios. The NAIC stress test assumed leveraged loan defaults ran one standard deviation above the historic 10-year average since 1970 and recoveries more than 20 percentage points below historic averages. The NAIC estimated that losses on its sample of leveraged loans averaged 19.1%. As for CLOs, classes rated ‘BBB’ or below incurred principal losses while classes rated ‘A’ or above did not.
Even though banks tend to primarily hold ‘AAA’ CLOs likely protected from actual losses, the bigger risk likely is from price declines. At the height of concerns about energy in early 2016, spreads on ‘AAA’ CLOs reached 186 bp or higher, more than 72 bp higher than current levels. Assuming a 4-year spread duration, that would imply about $3 decline in the price of a typical ‘AAA’ CLO. The price decline would put some pressure on the largest banks’ regulatory capital, although CLO exposures as a share of total assets are small.
Recent Fed proposals to modify some provisions of the Volcker rule, also covered earlier by APS, have arguably made it easier for banks to own CLOs. The proposed changes would allow banks to hold CLOs with up to 5% of assets in non-loan instruments. Banks could also hold a limited amount of equity that might come out of debt restructurings. And other provisions clarify features that might constitute an ownership position in a CLO and force divestiture. But the focus on leveraged loans and CLOs in the Fed’s 2020 stress tests could cool some of the potential new interest, especially from larger banks subject to the heightened stress test. Banks not subject to heightened stress, however, are likely to move ahead.
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