Is a bank collapse coming due to bank exposure to collateralized loan obligations as defaults increase?
Topics covered include
- What are collateralized loan obligations (CLOs), how are they structured, and what has been their historical default rates.
- How much exposure do banks have to CLOs and will it impact your bank savings and investments.
- What are bank capital ratios and how are they calculated.
- How banks are more conservatively run due to the adoption of the Basel III regulatory framework.
- What are bank stress tests and how have they performed.
- Why the Federal Reserve just capped dividends for the largest U.S. banks.
- How many U.S. banks have failed during the pandemic crisis compared to the Great Financial Crisis.
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 305. It’s titled, “How Safe Are Banks?”
Last month I had several Plus members share an article with me that was published in The Atlantic titled “The Looming Bank Collapse.” The subtitle was “The US Banking System Could Be on the Cusp of Calamity, This Time We Might Not Be Able to Save It.” The article was written by Frank Partnoy, he’s a law professor at UC Berkeley.
That’s a pretty ominous title. We want to look at the article, as well as the state of US banks and banks around the world. Should we be worried? Given the pandemic, is the banking system poised to collapse?
I was especially interested in the article because it came out right after I had increased my allocation to preferred stocks and added a preferred stock ETF to the Money for the Rest of Us, Plus model portfolios. The particular preferred stock ETF that we used by iShares has about 26% allocated to banks. And if banks are on the cusp of this calamity, that does not bode well for preferred stocks.
Collateralized Loan Obligations
In the article, Partnoy is particularly worried about banks’ exposure to an esoteric security called a collateralized loan obligation, or a CLO. We discussed CLOs back in episode 206 in May 2018. Collateralized loan obligations are asset-backed securities issued by special purpose vehicles or SPVs. The SPV purchases leveraged loans, which are non-investment grade bank loans that have been syndicated.
A bank will make a loan to a non-investment grade company, a higher risk company, and then sell that loan into the marketplace. Many of those purchasers are CLOs. There’s over a trillion dollars of leveraged loans outstanding, and most are held as part of these collateralized loan obligation structures.
The way it works is the SPV sells debt and equity securities that comprise the CLO. Those securities are backed, or collateralized, by the leveraged loans. The CLO has multiple layers, or tranches, that are sold separately. The debt layers are rated by credit quality. So the senior layer is AAA. There are lower-rated debt layers known as mezzanine layers. And then there’s an equity layer which is unrated. The payments on the underlying leverage loans, those payments are pooled together and flow in order. The first payments go to the senior AAA layer, then to the lower-rated layers, and then finally to the equity layer. That is known as a waterfall.
The debt tranches are over collateralized, in that a CLO might have issued $500 million in debt securities as part of the CLO that are backed by $625 million worth of leveraged loans, with the additional $125 in loans funded from selling the equity tranche.
Each CLO has about 150–225 loans. And because the leveraged loans themselves are floating-rate notes, their interest rates will fluctuate as short-term interest rates change. The debt tranches within a CLO are also floating grade, so there’s some protection if interest rates rise. Now because of this waterfall structure, the equity tranches take the first losses. Then the lower-rated debt tranches. And finally, if it gets to that, the senior, AAA tranche suffers losses. That hasn’t happened before.
The S&P does a global CLO report looking at default rates. And from 1996-2018 the overall default rate for CLOs was 0.5%. The worst vintage year was CLOs issued in 2008. There the default rate was 1.7%. There have been no defaults in CLOs issued between 2009 and 2018. And from the 1996-2018 period, there has never been a default for the AAA tranche. And only 1 default for the AA tranche.
Now as you know we are in a pandemic. And defaults within the high-yield bond and leveraged loan space is increasing. Fitch estimates the 12-month default on leveraged loans is 4%. And that more than $200 billion of leveraged loans will default through year-end 2021. That equates to a 2-year cumulative default rate of 15%. Just because leveraged loans are defaulting, doesn’t mean all the different tranches of the CLO is experiencing a default.
I saw a report on the Wall Street Journal from mid-May that showed about 10% of CLO managers have been diverting cash flow away from equity investors and going to the debt tranches, which means there have been defaults that are starting to impact the junior equity tranche. What is different from this cycle, though, is leveraged loans are more risky, and we discussed that in episode 206. The covenants on these loans are less restrictive, the credit quality is lower, the financials are weaker. And so we should expect defaults to increase.
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