Keeping some of the risk of collateralized loan obligations makes sense, but it might not be enough
European bankers have found a creative way to keep their debt-buying machine going: by keeping some of the risk for themselves. It may seem complicated for banks to buy the senior tranches of collateralized loan obligations (CLOs) they arrange, but it makes sense. The biggest problem is that these measures may not be enough to keep pace with this $1 trillion market in 2023.
CLOs pool purchase loans and divide them into securities with different levels of risk. Asset managers such as Blackstone or Axa select the underlying loans, while investment banks underwrite the CLO securities and place them with credit investors. Many of the bonds that come out the other side earn an ultra-secure AAA credit rating. In 2021, global volumes exceeded $220 billion, making CLOs a key player in financing venture capital deals.
However, rising rates are dampening their appeal as investors can earn relatively high returns elsewhere, such as government bonds. According to one banker, to entice investors to buy even the AAA-rated CLO tranches in Europe, the organizers have had to increase the return to more than 200 basis points above risk-free rates, compared to a spread of 80 basis points in early 2022. Some prime bond buyers, such as Japanese banks, have backed off. According to JP Morgan analysts, the combination of higher financing costs and a slowdown in venture capital operations has led to a 67% year-on-year decline in European CLO sales.
Bankers are finding a way to keep things going. Société Générale, BNP and Deutsche Bank, for example, are investing their own money in the senior tranches of the CLO trades they arrange, according to Bloomberg. It looks like a repeat of the 2008 disaster, when banks were stuck with unsaleable mortgage securities. But it is less risky than it seems. Typically, the highest rated CLO tranches are only affected when global losses on the underlying loans exceed 35%. Thus, for example, 70% of the entire portfolio would have to default, and creditors recover only half of their money, before the AAA tranches would suffer losses. And the significantly higher spreads in 2022 imply that bankers are being well compensated for that risk.
But the banks cannot run the show alone. If credit investors, such as hedge fundFearing a looming recession, they are likely to steer clear of riskier CLOs, which are the first to suffer the effects of VC-backed firms failing. The slowdown in the economy may also lead to downgrades of CLO loans and bonds, causing investors to demand higher returns. And the rise in debt continues to weigh on venture capital operations, limiting the supply of underlying loans. So the biggest CLO risk to banks is an even bigger slowdown, not an explosion.
