Uncategorized
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.
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.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
