May 28, 2019 - Lawmakers and regulators are continuing their inquiry into whether loans create systemic risk. In recent weeks, senior regulators have explained why they believe leveraged loans do not create systemic risk. Meanwhile, the House Financial Services Committee announced that on June 4, 2019 the Subcommittee on Consumer Protection and Financial Institutions will convene a hearing entitled, “Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending”. The LSTA encourages rational inquiry into the leveraged loan market; we expect both regulators and lawmakers to do their due diligence. And we believe that rational inquiry will demonstrate what we’ve discovered: that the leveraged loan market is not a threat to U.S. or global financial stability.
The LSTA has done extensive research into this issue, publishing a number of presentations and FAQs (here and here) describing the variants of risk in the loan market. We define credit risk as the likelihood of investment loss; while the market has exhibited appetite for more credit risk than it did earlier in the financial recovery, it is too early to determine if the investment loss experience will be similar to 2007. In contrast, we observe a decrease in systemic risk in leveraged loans since 2007. This is due in large part to the fact that, while some loan holders could be “forced sellers” in 2007, loan holders are much stronger now. In particular we note that:
- There is significantly less “mark-to-market” leverage used by investors. While the loan market is larger today, Total Return Swaps (TRS) are one-third the size they were in 2007, and use far less leverage. Meanwhile, Market Value CLOs (which have “mark-to-market” triggers) are basically non-existent.
- Leveraged loan pipeline exposure by underwriting banks is much lower than in 2007. In 2007, banks’ underwritten-but-unsold pipeline topped $300 billion. Today it is around $85 billion.
- Today, Open Market CLOs, which have match-funded assets and liabilities and are not subject to redemption risk or forced selling, hold roughly half of all leveraged institutional loans outstanding. Because they are never forced sellers, these CLOs are a stabilizing force in the loan market.
Indeed, based on their own research, a number of senior regulators have come to a similar view. In a recent speech reported by MarketWatch, Federal Reserve Vice Chairman Randall Quarles indicated that the media had been overplaying leveraged loan risk such that it seemed like “the Earth must be getting hit with an asteroid.” He went on to observe that banks were not holding these loans on their books, but rather selling them into “more stable holding structures” like CLOs. He noted that “you wouldn’t expect that to be systemically destabilizing.”
In drawing comparisons to 2008, we’d further note that, unlike CDOs, CLOs performed remarkably well during the financial crisis. Loss experiences in CLOs was de minimus; there has neverbeen a default in a CLO AAA or AA tranche in their nearly-30-year history. Moreover, S&P research shows that the default rate on CLO tranches rated A, BBB and BB is far lower than the default rates on equivalently rated corporate bonds.
Moreover, today’s CLOs are structurally safer than before, with more investment limitations and greater subordination than the pre-crisis cohorts. The LSTA demonstrated in these charts that even if loan defaults were higher than 2007 and recovery given default were lower than in 2007, the vast majority of CLO tranches – and certainly the AAA and AA tranches held by banks – would not be impaired.