Answers emerge from the murky business of CLOs.
There has been quite some hoopla surrounding Collateralized Loan obligations (CLOs) because the underlying leveraged loans – junk-rated loans often used by private equity firms to fund leveraged buyouts (LBO) and other high-risk endeavors such as special dividends – are now starting to come apart. There are approximately $700 billion in US-issued CLOs outstanding.
US banks hold $99 billion of these CLOs, according to S&P Global Market Intelligence. The rest are held by various institutional investors, such as insurance companies, pension funds, mutual funds, hedge funds, private equity firms, and the like. They’re also held by entities overseas, including certain banks in Japan that have gorged on these US CLOs. But that’s their problem.
One third of the CLOs in the US banking system are held by just one bank: JPMorgan Chase; and 80% of the CLOs in the US banking system are held by just three banks. But at each of these three gigantic banks, CLOs account for only 1.2% to 1.3% of total assets (total asset amounts per Federal Reserve Q1 2020):
- JPMorgan Chase: $34.0 billion in CLOs = 1.3% of its $2.69 trillion in assets.
- Wells Fargo: $24.6 billion in CLOs = 1.2% of its $1.76 trillion in assets.
- Citigroup: $21.4 billion in CLOs = 1.3% of its $1.63 trillion in assets.
In 11th position down the list is the second largest bank in the US, Bank of America, with just $807 million in CLOs, accounting for barely over 0% of its $2.03 trillion in assets.
In other words, the largest four banks in the US hold $81 billion of the $99 billion of CLOs in the US banking system – but given the gargantuan size of their assets, this percentage-wise small CLO exposure is the least of their problems.
They’re far more exposed to the classic banking risks during a crisis: Residential and commercial real estate loans, consumer loans, energy loans, and the like. And that’s where their major loan losses will come from – and are already coming from.
The next $8.2 billion of CLOs in the US banking system are held by two US banks. Turns out, the relatively small group, Stifel Financial, is heavily exposed:
- Stifel Financial: $4.3 billion in CLOs = 16.6% of its $25.9 billion in assets.
- Bank of New York Mellon: $4.1 billion in CLOs = 1.1% of its $387 billion in assets.
The next $8.1 billion in CLOs are spread over four large banks. The exposure of the smallest bank among them, BankUnited, is relatively three times as large as that of the other banks, but is still only 3.3%:
- TD Group US Holdings: $3.1 billion = 1.0% of its $320 billion in assets.
- State Street Corp. $2.7 billion = 1.1% of its $242 billion in assets.
- MUFG Americas Holdings: $1.3 billion = 1.0% of its $133 billion in assets.
- BankUnited: $1.1 billion in CLOs = 3.3% of $32.8 billion in assets.
The remaining $2 billion in CLOs in the US banking system are small fry spread over other banks. And Stifel Financial is the only major US bank seriously exposed to CLOs.
But what parts of those CLOs are banks holding?
Risks and losses — and therefore yields — with CLOs depend on the tranches. Banks generally hold senior tranches. The yields of senior tranches are low, but their risks are also considered low, because in case of a default of an underlying loan, based on the waterfall payout structure of the CLO, the equity tranches (usually 10% of the CLO) eat the first losses, then the junior tranches eat the remaining losses. And when losses continue, the mezzanine tranches get to eat those losses.
Investors in those tranches are compensated with higher yields for the risks of having to take the first loss. And they shouldn’t complain when they get their faces ripped off.
The senior tranches, which tend to be over half of the CLO, will be impacted after the lower tranches are wiped out.
The loans underlying the CLOs are secured by collateral, which can be sold in case of default. So when a loan defaults, the loss to investors is normally not 100%. Investors may be able to recover 40% through the sale of collateral. And the remaining loss then hits holders of the tranches of the CLO in the sequence of the waterfall.
Who goes after the low-yielding senior tranches? A report by the Federal Reserve found that 95.4% of the identified CLOs held by deposit-taking banks ($57 billion) and 60.4% of identified CLOs held by Bank Holding Companies ($20.6 billion) were senior tranches.
Investors are on the hook.
On the other hand, mezzanine, junior, and equity tranches accounted for over two-thirds of the CLOs held by investment funds, which include hedge funds and private equity funds, and they accounted for one-third of the CLO holdings of mutual funds.
This is where the vast majority of the risks are, and where the biggest dollar amounts are, and where the vast majority of the losses will be eaten.
“To summarize, our new data suggest that institutional investors have sizable exposures to risky CLO tranches,” said the Fed’s report.
“These risky holdings appear to be larger than what market participants believe,” it said (underscore added). “For example, analysis by Fitch Ratings shown in Table 3 suggests that pension funds only held AAA-rated notes,” [when in reality, they gorged on riskier tranches to get the yield].
So when these CLOs implode, they may cause minor ripples among a few large banks, amounting to less than a rounding error amid much larger loan losses; they may cause bigger ripples perhaps at Stifel; but they may cause some real heartache where the vast majority of the CLOs are held, and where most of the mezzanine, junior, and equity tranches are held: among mutual funds, hedge funds, PE firms, pension funds, and the like. And the Fed’s report points out, the heartache may come as a surprise to “market participants.”