Unchartered Vulnerabilities: Corporate Leveraged Loans and Collateralised Loan Obligations

In the aftermath of the global financial crisis of 2008-09, accommodative monetary policy, mainly through unconventional means, provided liquidity support which eased financial conditions in the crisis-hit economies of the U.S. and Europe.  But the low interest rate environment has encouraged greater risk-taking among corporates and non-bank financial institutions resulting in a build-up of corporate debt and larger holdings of asset-based securities, including collateralised loan obligations (CLOs).  The risks inherent in leveraged loans and holdings of CLOs may be exacerbated by deteriorating credit standards and weaker creditor protection, leading to greater risk of defaults, decreased recovery rates and investor risk aversion should macroeconomic conditions continue to worsen.

The recent Financial Stability Board report on Vulnerabilities Associated with Leveraged Loans and Collateralised Loan Obligations (2019) brings to attention the on-going debt accumulation of leveraged corporates and growing appetite for CLOs, which are asset-backed securities comprising of senior and mezzanine bond tranches and equity.  The report warrants several policy considerations.

First, although syndication of corporate loans through the securitisation of assets into varying tranches facilitates sectoral and cross-border risk-sharing, this financial innovation is susceptible to mispricing of risks and changing risk perceptions.  Unlike other forms of securitisation, CLOs entail high structural and asset quality risks reflecting lower credit quality of the underlying assets.  As such, weaker credit standards, including looser covenants and documentation weaknesses, will lead to less stringent lender protection and lower collateral quality.  The use of minimum risk retention requirement to align securitisers’ incentives with those of investors requires stronger regulatory and legislative support.

Second, international financial regulatory cooperation is needed to achieve a standard definition of leveraged loans and common concentration of CLOs.  The report clearly highlights the varying definition of leveraged loans between data providers as well as U.S. and European regulatory guidelines.  Varying criteria of what constitutes a leveraged loan increases the opacity of CLOs’ underlying loan assets.  Moreover, similar limits on the degree of concentration of loan pool between various regulatory agencies across jurisdictions is needed to properly assess default correlations and the price of risks.  For instance, European default correlations of CLO tranches tend to be higher compared to those in the U.S.  A higher default correlation may address concerns over risk evaluation and credit rating, while a lower default correlation entrails greater risk-sharing.

Third, data gaps from financial intermediaries must be addressed to identify sectoral and cross-border transmission mechanisms and channels whereby systemic and idiosyncratic shocks may propagate and amplify underlying vulnerabilities.  The report indicates that systemically important international banks have the largest exposures to leveraged loans and CLOs., while both investment and insurance companies have lesser exposure, although they hold lower-rated tranches than banks.  Cross-border data from these sectors are limited, while data on sectoral and cross-border holdings are unavailable for other non-bank financial intermediaries such as pension funds.  Specifically, the available data show that 79% of estimated leverage loans exposure and around 85% of total CLO exposure are accounted for by banks, investment funds, insurance companies and pension funds.  The remainder is known to be held by other pension funds, hedge funds, private debt funds and sovereign wealth funds.  These data gaps must be addressed as any shock or policy rate changes will have corresponding amplification and transmission effects through balance sheet and risk-taking channels both through direct and indirect channels which the report mentioned.

Given the projected global economic slowdown in the near-term, accommodative monetary policy may sustain appetite for leveraged loans and CLOs.  However, as corporate profits in advanced economies decline, risk perception may worsen.  With limited fiscal space, regulatory standards and oversight are even more needed.