May 20, 2015
Collateralized loan obligations may have gotten a bad rap after the financial crisis of 2008, but are they really to blame? Unlike certain types of securitized vehicles with static or unmanaged pools of mortgage-backed securities or auto loan portfolios, management of CLOs in undertaken by experienced asset managers who steer their portfolios away from certain risk by buying or selling loans in the primary or secondary markets. This is to ensure that credit quality of the loan portfolio remains healthy. Let’s take a closer look at CLOs and what their future looks like in today’s business environment.
The two sides of the CLO coin
The Lead Left explained that once managers book loans, those investments provide a steady stream of cash flow from the spread between asset yield and financing cost. While the spread fluctuates through business cycles, over time, managers who effectively manage credit quality of the pools of loans are able to improve performance and earn high single-digit to low double-digit returns. CLOs’ flexibility when dealing with stressed credits is particularly attractive for managers because they can hold on to certain assets for a higher recovery, or trade out of positions early, as the situation arises.
The Lead Left also conducted an informal survey of finance professionals to gauge industry sentiment with respect to CLOs. One loan syndication professional explained that while banks are effective at managing loans with mid-level credit ratings, during downturns, the lower levels are problematic.
“The fact is that banks do fine with double-B and high single-B credits, but our ability to ride through difficulties with lower credit quality assets is extremely limited,” the banker said.
Another loan professional talked about how banks lack flexibility when managing longer-term portfolio problems, especially on the bank’s balance sheet. This is one area where CLOs are especially helpful.
“To optimize recovery value in a work-out situation, you sometimes have to convert debt to equity,” he said. “That’s tough to do on a bank balance sheet, but in a CLO, it’s done all the time.”
It is important to point out that CLOs are not free from volatility. In the financial crisis, leverage loan funds and warehouse lines for CLOs that were marked-to-market received margin calls, which led to managers selling loans at distressed prices below value, noted American Banker. With underlying loans at depressed values, and for similar liquidity distress, CLOs traded at distressed prices below value as well. Obviously, the outcome was not favorable for anyone.
“CLOs that have not yet been Volckerized should be treated as assets held for sale.”
Banks need to “Volckerize” their CLO Holdings
New regulations are currently making CLO matters a bit more complicated. Reuters reported that The Federal Reserve has given banks until July 2016 to “Volckerize” their CLO portfolios, although some banks will receive a one-year extension through July 2017. American Banker discussed how the Volcker Rule prohibits banks from having an ownership interest in CLOs that invest in bonds. Most CLOs are made up of loans anyway, but sometimes they contain bonds as well. This has led to some managers’ desire to understand exactly what “ownership interest” means. Heath Tarbert, partner at Allen & Overy, told the news source that the regulators define it as any equity, partnership or other interest in a covered fund, irrespective of voting rights. As such, this interpretation will require many banks to restructure the CLOs already on their books. David Kreidler at Standard & Poor’s gave an indication as to the size of the restructuring that will take place to become Volcker-compliant.
“Roughly half of the approximately $350 billion of CLOs outstanding will need to amend structures,” said Kreidler, according to the news source.
Reuters noted that conservative accountants have argued that CLOs not yet Volckerized should be treated as “assets held for sale” and marked-to-market. That could result in significant fluctuations in banks’ earnings statements through those CLO interests.
CLOs are now prohibited from investing in bonds.
