Boom in securitized loan market echoes financial crisis, warns BIS

LONDON (Reuters) – Lending standards in the rapidly growing lending market are deteriorating and complex financial products that mask risks for banks have parallels to the 2008 financial crisis, the Bank for International Settlements warned on Sunday.

The number of secured loan obligations (CLOs), a form of securitization that pools bank loans to businesses, has exploded in recent years as investors seek higher returns by buying loans from lower-rated and higher-rated companies. risky.

Like asset-backed bonds (CDOs) that bundled US sub-prime mortgages into complex products and have been blamed for triggering the global financial crisis, CLOs also have complex structures that can hide the underlying risks.

The BIS said there were key differences between CLOs and CDOs that made the former less risky, but warned investors’ rush for higher returns was leading to deteriorating standards that could lead to bigger losses. in the future.

“Low underwriting standards can reduce the likelihood of short-term defaults, but increase potential credit losses in the event of default,” said Sirio Aramonte and Fernando Avalos, researchers at the Central Banks Coordination Group, in a quarterly report. .

The global outstanding CLO market is now estimated at around $750 billion, while the CDO market in 2007 before the crisis stood at $640 billion, the BIS said.

CLOs tend to be much less complex than CDOs and avoid the use of complicated credit derivatives, but the relaxation of credit standards and the lack of visibility into indirect ownership are common factors.

CLOs typically invest in loans to highly indebted companies with “junk” credit ratings, or those with high debt servicing costs relative to earnings.

Leveraged loans without maintenance clauses – which help protect investors in loans – rose from 20% in 2012 to 80% of all outstanding loans in 2018, while the share of leveraged loans low-rating in CLOs nearly doubled to 18%, according to BIS data. .

This has been accompanied by a steady increase in the debt ratio of borrowers.

The leveraged loan market has grown in recent years to about $1.4 trillion in circulation, of which about $200 billion is denominated in euros and the rest in US dollars.

This rapid expansion has been accompanied by a securitization of these loans into CLOs, with more than 50% of outstanding leveraged loans in US dollars and around 60% of those in euros now securitized via these products.

US and Japanese banks have been among the largest investors in CLOs.

Banks’ exposure to these products is concentrated in the highest-rated tranches, but ownership patterns among non-bank investors such as hedge funds and insurance companies are harder to trace.

Banks could therefore be indirectly exposed if defaults escalate, the BIS said.

“Like banks’ off-balance sheet exposure to CDOs, which was a source of instability in 2007, banks’ prime brokerage exposure to CLO holders could result in larger losses than those involved in direct exposures, creating increased financial stress,” the BIS said.

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Reporting by Saikat Chatterjee; edited by Tommy Wilkes and David Clarke

Priscilla C. Carnegie