- Leveraged loans are higher risk
- Assessments may vary widely
- Dealflow is poised to dip
Large banks will soon pay higher premiums to the Federal Deposit Insurance Corp. on assets now deemed “higher risk,” including products issued starting April 1 that are at least half collateralized by leveraged loans, sister service Thomson Reuters Loan Pricing Corp. reported. These loftier “FDIC Assessments,” the latest in a series of loan market regulatory hurdles, could widen spreads on even the highest-quality collateralized loan obligations to compensate affected bank buyers and at least temporarily stifle CLO issuance, analysts and investors said.
Market-makers expect heavy dealflow before April Fools’ Day, followed by a lull as bankers and investors assess their willingness to participate. Charges will vary by bank, based on a complex scorecard for institutions with over $10 billion in assets, making it difficult to gauge the fallout on leveraged loans and the CLOs that sop them up.
These securitizations rallied sharply from crisis lows. But leery regulators, in an October draft ruling, said the drop in value of CLO tranches with leveraged loan exposures “contributed to the liquidity crisis of 2008, which forced the U.S. government to provide unprecedented support to financial institutions and liquidity markets.”
The assessments critically apply to each CLO tranche equally, regardless of capital structure or credit rating. “It’s certainly important because getting the AAA tranche placed at an advantageous price is really the key to the whole CLO arb working. It’s two-thirds or more of the capital structure,” said Michael Kessler, credit strategist at Barclays.
“You can make the argument that the FDIC’s new insurance assessment rate is unfairly punitive with respect to banks’ CLO AAA tranche holdings, based on the fact that CLO AAAs historically have absolutely zero principal loss, and have generally achieved rating and price stability,” he added. “Nevertheless it’s going to be the new law of the land, and the market will adapt.”
Based on FDIC numbers, the final assessment rate will likely range between 2.5 basis points and 45bp annually, varying widely among banks, writes David Yan of Credit Suisse. That amount would effectively be lopped off the net coupon spread on AAA tranches a bank buys.
One side effect may be investors seeking lower-rated CLO tranches in their quest for extra returns. “If demand slows down more or for a longer time than expected, you might see issuers start to get creative with structures and try to have larger AA and A tranches and smaller AAA tranches” to meet demand, Kessler said. “If collateral spreads have to widen for the CLO arb to be restored, and that source of demand to come back to the loan market, the people that ultimately pay for that are the issuers.”
Leveraged loans will be deemed high risk commercial and industrial loans when sized at least $5 million and satisfying purpose, materiality and leverage tests. Under the first two tests, eligible loans would need to represent over 20 percent of a company’s funded debt and finance a buyout, acquisition or capital distribution. The leveraged tests then would qualify loans that exceed set ratios of debt to operating earnings.
“Because it’s so idiosyncratic, it’s very difficult to say how it will affect U.S. banks’ interest in buying new CLO notes,” said Meredith Coffey, executive vice president of research and analytics at the Loan Syndications and Trading Association. “But, bottom line, it can’t help.”
Leveraged loans face a series of regulations that could choke CLO creation, deter willing lenders and boost borrowing costs. Final U.S. leveraged lending market guidance is imminent, altering bank risk management’s blueprint for the first time in a dozen years. The guidance outlined by the Federal Reserve, FDIC and the OCC would materially increase loans on banks’ books classified as “leveraged” or “criticized” for repayment risk. Banks would thus need to beef up reserves to buffer potential losses, reducing money available for lending.
This year’s CLO issuance has shot up to $20 billion through mid-March on demand for higher yield and lower duration risk. That’s four times the volume in the same period last year. Some issuers could be front-running the assessments, industry sources said.
“If this assessment has a meaningful financial impact, or expense, to buying AAA, it could require these banks to demand a higher AAA spread to compensate them,” said David Frey, managing director at Highbridge Capital Management. “Or it may be a deterrent and they buy less than they otherwise would have, or potentially not buy at all.”
Likely spread widening could be tempered by a broader investor base and confidence based on historical safety.
CLO buyers increasingly include insurance companies, pension funds and other fixed-income investors as well as Japanese and U.S. banks, said Frey. “Theoretically it’s very, very difficult to impair a CLO AAA, and to my knowledge there’s never been a situation where an AAA has recovered less than par value.”
Lynn Adler and Billy Cheung are correspondents for Thomson Reuters LPC in New York.