Murk everywhere. There isn’t even an agreement what “leveraged loans” are. No, banks are not off the hook. They hold 57% of these instruments, the Bank of England found.
Leveraged loans are risky. They’ve been issued by junk-rated overleveraged companies that are often owned by private equity firms. These loans are often packaged into highly rated Collateralized Loan Obligations (CLOs). The Fed, the Bank of England, and other central banks are fretting about them publicly in their Financial Stability Reports. Leveraged loans are traded in slices like securities, but they’re loans, and not securities, and so securities regulators don’t regulate them, and no one regulates them. No one knows into whose balance sheets they can blow holes. And there is not even any agreement what exactly leveraged loans are.
In short, they’re risky and murky.
But investors have the hots for them all over the world. With about $13 trillion of global investment-grade debt trading at negative yields, thanks to idiotic central-bank policies focused on financial repression rather than a sound economy, institutional investors have to take on huge risks to get a little yield, and these leveraged loans and CLOs fit that bill perfectly.
Depending on whose definition of leveraged loan we use, there are either $1.3 trillion globally – these are the loans that are included in the S&P leveraged loan index – or, by a broader definition that Bloomberg uses and that the Bank of England (BOE) uses in its Financial Stability Report, $3.2 trillion.
“Given the lack of a consistent definition of leveraged lending, there is uncertainty over the total stock of outstanding leveraged loans,” the BOE says.
So the BOE’s staff fanned out to determine who holds this $3.2 trillion in leveraged loans and CLOs. They pieced together data from central banks, Bloomberg Finance, S&P global Market Intelligence, Morningstar, the National Association of Insurance Commissioners, the Securities Industry and Financial Markets Association, FCA Alternative Investment Fund Managers Directive, the SEC, public disclosures by asset managers, banks, and pensions funds, etc.
It wasn’t easy to break through the murk of leveraged loans and CLOs.
The big thing that we always assume is that leveraged loans and CLOs are largely held by investors rather than banks, and that banks are not heavily exposed to leveraged loans, and that bank balance sheets are largely immune to a potential meltdown of those instruments, and that it would be investors that would get hit by the losses, and that banks would get away with just a few contusions, so to speak.
But now we can throw these assumptions out.
According to the BOE, 57% of the $3.2 trillion in leveraged loans and CLOs are held by banks. That’s $1.8 trillion.
Banks end up exposed to these instruments in three ways:
- Loans that banks have originated but not yet sloughed off to investors (“pipeline exposure”). This was an issue during the Financial Crisis, when banks got stuck with those loans that then blew up. But this “pipeline exposure” is not included in the total bank exposure here.
- Loans they choose to hang to.
- CLO holdings.
Of those banks that hold CLOs and leveraged loans, Japanese banks have become infamous after the Japanese government got worried about it. But turns out, they’re just small fry. They held no leveraged loans at the end of 2018 and held only $96 billion of CLOs (though they might have added to that stash recently).
European banks held $448 billion in leveraged loans and $32 billion in CLOs.
US banks (and “other global banks”) are by far the largest holders, with $1.06 trillion in leveraged loans and $160 billion in CLOs, for a total of $1.22 trillion.
The table shows all holders, including the $224 billion held by unknown holders, (“unallocated”). All amounts in billions of dollars. Loan funds for retail investors – the three lines: open-ended funds, ETFs, and closed end funds – combined hold $416 billion, making fund investors, in aggregate, the second largest holders. Those are mostly retail investors. Hedge funds are the third largest holders. Remember that “pipeline exposure” is not included. (If your smartphone clips the table, hold the device in landscape position):
|Holder of Leveraged Loan or CLO||Loans, $ billions||CLOs, $ billions||Total, $ billions|
|US & other global banks||1,056||160||1,216|
|SMA (separately managed account)||64||0||64|
It’s fascinating how murky the data is around this $3.2 trillion pile of leveraged loans and CLOs. And the BOE is not shy about pointing it out, such as:
- “Complete data are not available for some non-banks, and so values have been estimated based on partial data.”
- “The grey segment ["unallocated” = $224 billion] marks the areas of most uncertainty”.
- “For hedge fund holdings of leveraged loans and CLOs, we scale up holdings reported to UK authorities by non-EEA managed alternative investment funds to reflect the size of the global hedge fund universe. This means these estimates are particularly uncertain.”
- “Data for insurers largely refers to US entities. A proportion of holdings are through products that are offered by insurers to outside investors.”
The BOE’s efforts to shed light on leveraged loans has at least succeeded in revealing just how much murk there is in this end of the industry. And it is doing away with the illusion that banks are mostly off the hook when leveraged loans and CLOs blow up.
Kudos to the private equity firm. These things don’t happen overnight for companies. They happen overnight only for investors. Read… Everything’s Fine Until Suddenly it Isn’t: How a “Leveraged Loan” Blows Up