September 19, 2014
The House passed a bill on Tuesday, Sept. 16 that would, among other things, alter Dodd-Frank to allow banks to hold the riskiest types of collateralized loan obligations (CLOs). It will soon come up for a vote in the Senate, where the odds of passage are less certain, but still strong. Bank regulators learned about the risks of mortgage- and other asset-backed securities in the recent financial crisis. They are intent on reducing such risks to banks. But lawmakers in the House seem intent on thwarting that effort.
To understand what’s at stake, it is necessary to understand CLOs. In a CLO, large high-risk business loans are pooled together and then securitized. The loan pool is sliced up and the slices sold to different groups of investors, with the riskiest slice — the one to take the hit first if one of the loans in the pool stops paying — yielding the highest rate of interest. The underlying loans are multimillion-dollar loans made by banks — usually to private-equity funds which borrow this money to acquire companies. The company’s assets are used as collateral for the loan — hence the designation as “collateralized loan obligations.” These are high-risk or “leveraged” loans that burden the company acquired in a “leveraged buyout” (LBO) with high levels of debt. The loans are below investment grade — essentially junk bonds. The bank that originates these business loans quickly sells the majority of the CLOs to new owners; however, it retains a part of the original bundle of loans.
In the first half of 2014, sales of CLOs reached $83.1 billion — more than were issued in all of 2013, and possibly heading for a record. Leverage multiples have risen dramatically. The stock market run-up means companies’ private equity targets carry a high price tag. Private equity funds can “afford” these high prices because they have easy access to credit and can burden the companies they buy with huge amounts of debt. The situation has gotten completely out of hand. According to PitchBook, which compiles data on private equity, median debt in LBOs by private equity funds was 8.2 times earnings (EBITDA) in the first half of 2014, up from 6.9 times in 2013 and the 5.7 times earnings that prevailed at the last peak in 2007 and 2008. This is far above the six times earnings suggested as the limit for debt in the guidelines on leverage issued by bank regulators.
The danger that highly leveraged loans may not perform well is very real, as creditors who loaned money in the last boom to such prominent private equity-owned companies as Hilton Hotels & Resorts, Caesars Entertainment, and Texas utility company Energy Futures Holdings (EFH) learned. According to FitchRatings, there were 10 LBO-related bond defaults in the first half of 2014, more than double the nine that occurred in all of 2013. While the default rate is relatively low, this can change quickly if the economy falters.
Regulators are worried. They remember what happened in 2008 when complex securitized debt instruments like mortgage-backed securities imploded. In its semiannual report reviewing 2013 trends, the Office of the Comptroller of the Currency (OCC), one of the banks’ regulatory agencies, expressed its concerns about the high issuance of CLOs: “The combination of higher leverage, lower yields, tighter credit spreads, and weaker covenant protections (for lenders) provides ample evidence of increasing credit risk in the leverage loan market.”
Whether regulators will be able to require banks to divest the riskiest CLOs is unclear. The section of the Dodd-Frank law known as the Volcker rule bars banks from making risky investments with their own money. It should have gone into effect in July 2014, but the deadline was extended by the agencies regulating banks for one year, to July 2015. The agencies tried to hold to that deadline, but the banks turned to Congress for help. As a result, the Volcker rule was tweaked to allow banks to keep any collateralized loan obligations that were issued before 2015 and delayed compliance to 2017.
Given the illiquid nature of CLOs, banks would have a hard time if the economy ran into trouble and they needed cash. CLOs are too risky for banks to hold. However, the part of the Volcker rule that applies to CLOs has been narrowly interpreted by the regulatory agencies. Banks will continue to be allowed to hold CLOs that “are comprised solely of loans” and related assets. But banks must divest the riskiest CLOs — those that include non-loan assets such as mortgage- or other asset-backed debt securities.
The bill introduced in the House by Rep. Andy Barr (R-Ky.) and Financial Services Committee Vice Chairman Gary Miller (R-Calif.) would exempt additional types of CLOs from the Volcker rule. CLOs are risky and illiquid assets that do not belong on banks’ books. Bank regulators are making a modest effort to reduce risk by requiring banks to divest the riskiest of the CLOs. Congress should not do an end run around the regulators and subject all of us to the risk of a Lehman-esque meltdown of a bank unable to meet its need for cash.
Appelbaum is a senior economist with the Center for Economic and Policy Research and co-author, with Rosemary Batt, of the book Private Equity at Work: When Wall Street Manages Main Street.