June 6, 2019 - Are leveraged loans systemically risky? A subcommittee of the House Financial Services Committee held a hearing this week to examine this very issue, one that the LSTA has scrutinized closely and that regulators, reporters and commenters have been mulling over for many months. (A webcast of the hearing is available here and the Committee memorandum is available here). Below, we review the hearing and address the major themes that emerged. In a nutshell, while none of the witnesses concluded that loans and CLOs currently pose systemic risk, concerns were raised about whether (a) loans could become systemically risky in the future, and (b) the loan market is too opaque for banking regulators to fully appreciate its inherent risks.
Background. The hearing was called by the Subcommittee on Consumer Protection and Financial Institutions. Belying the title of the hearing, much of its focus was not so much on the current systemic riskiness of the leveraged loan market but on the alleged opaqueness of the loan and CLO markets and whether that lack of transparency could lead to systemic riskiness while regulators remain in the dark. Indeed, three bills that are designed to address that perceived opaqueness were proposed in connection with the hearing. The first bill, Protecting the Independent Funding of the Office of Financial Research Act, would require that the Office of Financial Regulation (OFR) be funded at level no lower than its 2017 budget. The second bill, the Leveraged Lending Data and Analysis Act, would require the OFR to gather information and report to FSOC on the leveraged loan and CLO markets and assess risks to the economy and financial stability. The final bill, the Leveraged Lending Examination Enhancement Act, would require the Federal Financial Institutions Examination Council (FFIEC) to establish uniform examination procedures for financial institutions that conduct leveraged lending activities to ensure that such activities are done in a safe and sound manner.
The Testimony. Four witnesses testified at the hearing, three of whom, Erik Gerding of the University of Colorado Law School; Victoria Ivashina of Harvard Business School; and Gaurav Vasisht of the Volcker Institute were invited by the majority. The fourth, Greg Nini of Drexel University, represented the Republican minority. While conceding that the loan market does not currently pose systemic risk, the majority witnesses warned that the market was getting riskier and needed to be closely monitored. Gerding and Vasisht focused on the prevalence of “cov-lite” loans, but Ivashina was more concerned with the erosion of other creditors’ rights through “baskets” that loosen negative covenants and rising leverage ratios. The majority witnesses also worried about potential systemic impacts in the event of a downturn-driven market freeze and raised concerns over the alleged lack of information on who actually holds CLO liabilities. As Professor Ivashina put it, “Do they have stable funding? How levered are they?” Professor Nini, while recognizing the growth of the leveraged loan market, noted that it was commensurate with that of overall corporate credit and suggested that some of the growth could be attributed to firms substituting away from high-yield bonds. Nini agreed that certain investors would suffer losses in the event of a downturn but found little evidence to be worried about systemic risk. First, he did not find current pricing or terms in the loan market alarming, noting that virtually every cov-lite loan has a connected covenant-heavy bank loan component and that the average interest rate spread on leveraged loans is only slightly below historical averages. And (consistent with LSTA presentations and FAQs (here and here) describing the variants of risk in the loan market), Nini concluded that the loan market is not subject to a “bank run” given that such a large portion of the market is held by non-mark-to-market, long term investors such as CLOs. Finally, Nini’s research also demonstrated that even if the loan market were to “freeze up” (as it did in 2009) most borrowers would substitute to different sources of capital and not suffer adverse consequences.
The Hearing. Many Democratic Congressman raised questions about the alleged opaqueness of the loan and CLO markets, suggested that CLOs are similar in many ways to CDOs and noted that no one expected CDOs to fail so spectacularly. Accordingly, they strongly supported the proposed legislation empowering the OFR and FFIEC to examine leveraged loans and CLOs. Most Republicans pushed back, arguing that the banking agencies are carefully following the loan market and explaining that CLOs are very different from CDOs and actually performed very well through the financial crisis and over a 30-year period.
Analysis. Based on the LSTA’s research, the concerns raised by the majority witnesses seem to be largely misplaced given the historical performance of CLOs and their underlying loans as well as the structural protections for investment CLO securities. As the COW demonstrates, historical default and loss rates on leveraged loans are far lower than the subordination under a CLO AAA tranche. In effect, to incur actual credit losses on a CLO AAA tranche, the loan market would have to suffer a default rate of 100% married to a recovery rate of less than 65 cents. It is virtually impossible for such a scenario to occur outside of an absolute global catastrophe. Similarly, as these charts demonstrate, it would take historically high default levels combined with very low recovery rates to materially impair any of the other rated notes in a CLO. (In addition, the witnesses’ concerns about the opaqueness of CLO ownership also appears to be overstated. As we will demonstrate next week, there is significantly more visibility into CLO holdings than the witnesses would leave one to believe).
Conclusion. Whether or not the proposed legislation moves forward (and, given the Republican majority in the Senate, that is unlikely), it is certain that the hearings will not be the last word on the nature of the risk in the loan market. We will continue to follow this issue closely.