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BANKING & INSURANCE Big Banks Are Very Exposed To Leveraged Lending And CLO Markets Mayra Rodriguez Valladares Senior Contributor Follow Apr 15, 2019,06:00am EDT This article is more than 4 years old. Banks and non-banks are very interconnected. Banks and non-banks are very interconnected.GETTY During last week's House Financial Services Committee hearing, Holding Megabanks Accountable: A Review of Global Systemically Important Banks 10 years after the Financial Crisis, Representative Jim Himes (D-CT) asked the seven chief executive officers of America's largest banks "What product, financing mechanism, or market is do you think is generating systemic risk which we should pay attention to?" Almost all of them mentioned that leveraged lending was a top product that we should focus on. Congressman Jim Himes Congressman Jim HimesHTTPS://HIMES.HOUSE.GOV/ABOUT Citigroup CEO Michael Corbat responded that "People talked a lot about leveraged lending and what that's done. I don't believe to date it is systemic because most if it is driven outside of the regulated financial system." And Goldman Sachs CEO David Solomon stated that "As people talk about leveraged lending, they think about that on the backs of the large institutions here. But there's more and more direct lending being done in separate vehicles that's not regulated, not scrutinized. At the moment, I don't think it's systemic, but it is growing, it's obscured and I think that we need to have a closer looking." As I wrote a few months ago, non-banks need a lot more vigilance, and they should certainly be more transparent about their role in leveraged lending. While it is true, that an increasing amount of the leveraged lending is being underwritten by non-banks, such as private equity and securities firms, as of 2018, banks in the U.S. were still the largest leveraged loan underwriters. Largest U.S. Leveraged Loan Underwriters in 2018 Largest U.S. Leveraged Loan Underwriters in 2018DATA SOURCE: BLOOMBERG In 2019, thus far, a number of non-banks have increased their leveraged loan underwriting significantly. There have been market share gains for Kohlberg Kravis Roberts (KKR), Antares Capital, Golub Capital, and Ares. Yet, for the moment, banks are still the biggest underwriters. Largest Leveraged Loan Underwriters in 2019 Largest Leveraged Loan Underwriters in 2019DATA SOURCE: BLOOMBERG By no means are banks immune to any downturn in leveraged lending. As pointed out in a very detailed research piece last week by Standard and Poor's LCD News, "Banks and hedge funds, which over the past few years have taken a back seat to collateralized loan obligations and other institutional investors in the $1.19 trillion U.S. leveraged loan market, have regained market share in recent months amid a rockier, more risk-off environment." Banks are very exposed to leveraged loans in several ways. For example, banks have leveraged loans on their books which they have underwritten, provide loans and a wide range of credit lines to non-banks who use those funds to underwrite leveraged loans to a wide range of companies and financial institutions, buy 50% of the collateralized loan obligations, many of which contain leveraged loans, provide loans and a wide range of credit lines to insurance companies, pension funds, university endowments and other investors that buy collateralized loan obligations (CLOs), and are counterparties to credit default swaps which banks and non-banks use to protect against leveraged loan or CLO defaults. According to recent Bank for International Settlements data, leverage lending is now about $1.4 trillion, with about 71% of that lending underwritten in the U.S. In the U.S., leveraged lending is now higher than the amount outstanding of high yield bonds. Global leveraged lending Global leveraged lendingBANK FOR INTERNATIONAL SETTLEMENTS Additionally, the vast majority of leveraged loans are covenant-lite which means that if any of those borrowers default, both bank and non-bank lenders will have very little protection against loss severities. Most leverage loans in the U.S. are covenant-lite. Most leverage loans in the U.S. are covenant-lite.LCD Currently there are five exchange traded funds (ETFs) that invest in leveraged loans, according to ETF.com, and Reuters reported that two companies are planning to introduce new ones. In terms of mutual funds, Morningstar shows that at least 30 managers that offer leveraged loans. In addition to these investors, there has been a recent rise in retail and family office investors. Many banks and non-banks sell a good part of the leveraged loans on their balance sheets to a variety of funds and especially, to special purpose vehicles which package the loans and sell them as fixed income products called collateralized loan obligations (CLOs.) Other can be bank and non-bank balance sheets as well as different funds. Most leveraged loans are in CLOs.SOURCE: CITIBANK RESEARCH, 2018. New CLO issuance and total CLO volumes outstanding have continued to grow since I last wrote about this in November 2018. Since 2000, CLOs outstanding in the U.S. have grown from $72 to $616 billion, an almost 760% rise. That rise is significantly higher than that of total collateralized debt obligations (CDOs) outstanding in the US, which have risen 364% in the same time period, because there has been a significant decrease in other types of CDOs, such as structured finance CDOs. CLO volumes outstanding have risen over 700% in almost two decades. CLO volumes outstanding have risen over 700% in[+] DATA SOURCE: SIFMA Presently, the value of CLOs outstanding is higher than any asset-backed securities including auto loan ($223 bn), student loans ($170bn), credit card ($124bn), and other ($267 bn). The volume of CLOs outstanding is higher than the volume of any asset-backed securities. The volume of CLOs outstanding is higher than the[+] DATA SOURCE: SIFMA New CLO issuances were about $125 billion in 2018, an astronomical rise from 2009 when the issuances were practically zero. CLO issuances in 2018 were far higher than in every asset backed securities category, auto loan ($107 bn), credit card ($31 bn), equipment ($26 bn), student loan ($19) and other ($52 bn). Just about every type of financial institution buys CLOs. About 50% of the buyers globally are banks, so a downturn in leveraged lending and subsequently in CLOs would certainly hurt banks. The other 50% include insurance companies, assets managers, hedge funds, and structured credit funds, which are all interconnected to banks because they borrow money from them or they are counterparties to them in transactions like financial derivatives. Banks own half of the CLOs outstanding. Banks own half of the CLOs outstanding.CITIBANK The majority of the buyers are in the US, followed by Europe, Japan, and a minority in the rest of the world. U.S. investors own the vast majority of CLO tranches. U.S. investors own the vast majority of CLO[+] CITIBANK Bank executives and senior managers are quick to argue that since they tend to buy senior and mezzanine tranches, they have the safest tranches which have a low probability of default. However, if those tranches are downgraded or become less liquid, this could push prices down precipitously, causing significant mark-to-market losses. Any shock could cause significant market risk in the form of rapid price declines. Any shock could cause significant market risk in[+] WORLD ECONOMIC FORUM Banks remain the largest arrangers of CLOs; thus far in 2019, Morgan Stanley, Citigroup, Barclays, JP Morgan, and Bank of America are the top five arrangers. Typically, banks invest in CLOs through their securities legal entities to keep inventory for customers who may buy these assets or through the banks' asset management entities in order to include CLOs in clients' investment accounts. The largest bank buyers of CLOs in the U.S. are Wells Fargo, JP Morgan, and Citigroup. It is not just U.S. banks that buy U.S. CLOs; they are bought globally. In the last 12 months, Japanese banks have become significant investors of European and US CLOs. In the last nine months of 2018, Norinchukin Bank increased its CLO holdings by almost 80%. Wells Fargo, JP Morgan, and Citi are the largest bank owners of CLOs. Wells Fargo, JP Morgan, and Citi are the largest[+] CITIBANK Himes is right to keep asking what potential risks could materialize in the U.S. banking system. I urge other politicians to join him in asking that question of all bank executives several times a year and to look for ways to mitigate risks to taxpayers. None of us can afford to be complacent. Answer the following question In this forum discuss the collateralization process and the reasons underlying the decisions by financial institutions to collateralize their loan portfolios. Think about how this process creates a wide dispersion of risks associated with this type of assets beyond their origination point. Furthermore, consider the growth and size of CLO of leveraged loans (loans to highly indebted companies) as a source for triggering another financial crisis when a conflation of events such as a deterioration in the economy, deflation of asset prices and rising risk of default, etc. occur. Evaluate the extent of interconnections within the financial industry that can magnify risks to the financial system.