April 3, 2019 - On Tuesday, LSTA’s Meredith Coffey joined a panel at the IMN European Loans and CLOs Conference to share US perspectives on regulations (and rumors). Specifically: Systemic risk, Japanese Risk Retention and LIBOR transition. We offer the key US takeaways (and deeper links for the intrigued).
First up, regulators’ views on loans, credit risk and systemic risk. As previously discussed in these pages, we believe that there is a conflation of credit risk (the risk of default and loss in an investment) and systemic risk (the risk that a spiral in loan prices could create a crisis). To be fair, credit risk has increased since the early post-crisis period. Leverage has climbed, subordination has declined and loan terms – such as EBITDA adjustments, debt incurrence language and collateral transference ability – have deteriorated. All this suggests that, when loan defaults, currently at a seven year-low, emerge, recovery given default will be lower. But the potential of loss is a risk that investors accept – just as they do when they buy FAANG stocks. Systemic risk, meanwhile, remains lower than in 2007. There are fewer “weak holders” of loans and there is far less mark-to-market leverage in the loan system. Consider this: In 2007, the leveraged loan pipeline grew as large as $250 billion, according to LPC. When the market stopped, underwriters were forced sellers, triggering substantial declines in loan prices. Second, there also was an estimated $250 billion of mark-to-market total return swaps in the loan market. As prices fell, TRS became forced sellers, driving prices down even further. Where do these numbers stand today? The average leveraged loan pipeline was $50 billion in 2018, while there’s an estimated $90 billion of (lower levered) TRS programs outstanding. Perhaps this is why, when asked in a Congressional hearing about the leveraged loan market and systemic risk, Fed Chairman Jerome Powell noted that while there was macroeconomic risk, particularly in the event of an economic downturn, they “don’t believe it poses the systemic kinds of risk.”
Next, up was Japanese risk retention. As detailed last week, Japanese risk retention is not all about risk retention. Instead, it is about the safety of Japanese investors in securitizations. With this in mind, there are two major prongs of JRR. First, the Japanese bank investor must have the systems and capability to analyze their securitization investment. If they cannot demonstrate these capabilities, they cannot invest in securitizations. Period. If they do have these capabilities, they can invest in securitizations, but either i) the manager must retain 5% of the fair value of the securitization or ii) it must be determined “that the original assets were not inappropriately formed”. We think the U.S. market may take the second road.
The final US-related topic was LIBOR transition. With the foundational assumption that LIBOR will end after 2021 in mind, we identified – and CreditFlux reported – five major steps loan market participants should consider. First, understand the potential new reference rates (like SOFR) and how they differ from LIBOR. Second, take an inventory of exposure, including everything such as CLO notes, loans, FRNs, hedges and more. Third, develop workable fallbacks for new loans and CLOs. (Note: The ARRC Bank Loan Working Group has been developing fallback language and hopes to make public recommendations soon.) Fourth, ensure loan systems can operationalize the replacement rates and fallback options. And, fifth, consider beginning to issue new debt based on the replacement rate. After all, in a hypothetical world where LIBOR contracts have all been replaced, there is far less LIBOR transition risk.