A May 5th Wall Street Journal article, “Banks Revive Role in Complex Debt, Lenders Had Eschewed Loan-Bond Leverage Since Crisis, but New Rules Spur Them to Seek Buyers” by Katy Burne examines the growth of leveraged investors in the CLO markets. Let’s take a closer look.
The article described the re-emergence of investors buying CLOs and obtaining leverage on those investments. We have written before about repo desks increasingly moving toward spread product (“Tri-party equity repo jumps up 40% yoy as repo desks shift to more volatile collateral in search of P&L. But will the Fed look kindly?”) and CLO leverage is a classic example. From the article’s opening paragraph:
“…Banks again are doling out money to hedge funds and other investors to finance purchases of complex debt securities, returning to a practice that helped fuel the debt boom ahead of the financial crisis…”
It is the confluence of four events driving this activity:
- The stronger economy is presenting more opportunities to banks to make loans to lower rated corporates
- The lack of volatility in the FI markets — sometimes it feels like a redux of the “Great Moderation” — has squeezed spreads down, pushing investors toward riskier investments to realize returns while at the same time increasing confidence about the investments
- Banks want to keep their origination machines going, but don’t have the capital to let the loans sit on the balance sheet
- Repo desks have been under pressure to take spread where they can find it — and CLO leverage at L+75 sounds pretty good when compared to US Treasury or Mortgage business at a fraction of that
There is also a sense that if simplified capital rules take the risk weighting out of balance sheets, that when the capital police finally descend to allocate resources, there better be something other than UST and Agency business on the repo books to make budget.
LCR and NSFR rules may create a bottleneck in the growth of CLO repo (and other types of story paper financing as well). Those rules push repo desks to find term funding against the financing trades on the books. That will require a certain amount of salesmanship to get it done. But Wall Street traders have been pretty inventive on that side too. We are, of course, referring to the use of repo conduits and collateralized commercial paper to fund less liquid securities. Their use will inevitably grow as repo businesses push funding non-HQLA and have to more actively manage their regulatory funding risk. Finadium wrote about this last October in a report entitled “Collateralized Commercial Paper: Regulatory Arbitrage or Elegant Solution?”
Haircuts on CLO leverage are reported to be 10% to 20%. Those look like pretty decent levels, especially since CLOs did fare well during the financial crisis. But as ever, the devil is in the details. Not all loans are created equally. Information on the underlying deals need to be watched carefully. Repo desks are sufficiently removed from the origination process and sometimes are not experts on the ins-and-outs of esoteric collateral. Thinking loans act the same as Treasuries — or even Equities or Corporate Bonds — would be a mistake. Loans have episodic liquidity and the alternative, should there be a default of the underlying and the financing counterparty is no where to be found, is the long less-than-fun process known as “loan workout”.
The article said,
“…Overall, borrowed money is mostly used to buy triple-A-rated CLOs, say bankers and investors. That contrasts with the run-up in the 2008 crisis, when huge sums were borrowed to finance bets on assets such as subprime mortgages…”
By the way, a lot of those subprime mortgages were packaged in RMBS and were — wait for it — AAA. At least for a time.
Investing in CLOs is a logical result of compressed spreads pushing investors into riskier products. When those spreads aren’t enough to satisfy, enter the leverage. Some of us have seen this movie before.
The article is behind the WSJ paywall. We apologize if the link doesn’t work.