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San Francisco Regional Outlook - Third Quarter 1998

In Focus This Quarter CLOs Lure Another Major Bank Asset off the Balance Sheet Securitization of corporate loans and bonds is in full swing, with 1997 issuance exceeding that of securities backed by credit card loans. Collateralized loan obligation (CLO) and collateralized bond obligation (CBO) issuance has grown dramatically since 1996. Both CLOs and CBOs are potential bank investments that may grow in popularity if a current proposal to lower the risk weights for AAA-rated securities is enacted. These bonds may offer a higher yield than other AAA-rated securities, but they also may carry both deal- and issuer-specific risks that warrant closer scrutiny. Banks with an ample supply of low-margin commercial loans are expected to issue more CLOs to an increasingly demanding secondary commercial loan market. Securitizing investment-grade commercial loans has implications for capital adequacy. CBOs and CLOs are fixed-income securities that share many similarities with other asset-backed securities. In a CLO or CBO, commercial loans or bonds are pooled and securitized, and participation certificates in the underlying assets are sold to investors. The first CLO and CBO transactions occurred in the late 1980s, but issuance was slow until last year. During 1997, the estimated volume of corporate bonds and commercial loans securitized was $54 billion, more than double the amount securitized in 1996. In fact, the combined issuance of CBOs and CLOs in 1997 was more than the amount of credit card loans securitized during the year. The amount of securitized commercial loans and corporate bonds is expected to continue to grow this year, with an increasing number of deals backed by commercial loans1 (see Chart 1). 1 CBOs/CLOs: An Expanding Securitization Product, p. 1, JP Morgan, September 1997. Chart 1 CBOs and CLOs: A Natural Development in the Asset-Backed Securities (ABS) Market The growth of the CLO market can be explained by several supply and demand factors. On the demand side, strong investor appetite for ABS has produced tremendous growth in the securitization of consumer loan segments such as credit card, auto, and home equity loans. The increasing comfort level of the capital markets with these asset classes and the various structures used to securitize them has facilitated the ABS market's expansion into nonconsumer loans, including corporate debt obligations and bank commercial loans. CBO and CLO structures represent a natural progression from the securitization of a pool of consumer loans to the securitization of a diversified package of corporate bonds or bank loans. Increased standardization of terms among commercial lenders and more information flow on returns, defaults, and recoveries also have made commercial loans and corporate debt more desirable to institutional investors and an asset class viable for securitization. In addition, CLOs provide a way for investors, including banks, to own a credit-enhanced interest in a diversified pool of loans without directly owning the individual loans. Investors are increasingly considering collateralized bond and loan products as higher yielding alternatives to other ABS. Foreign and, to a lesser extent, domestic banks have been large purchasers of CLOs and CBOs. Bank investment in CLOs and CBOs primarily has been in the most senior, highest investment-rated tranches. Together, foreign and domestic banks are estimated to have purchased almost one-half of the highest rated classes of CLO and CBO securities issued in 1997. Insurance companies dominated the purchase of the middle or mezzanine class of CLOs and CBOs.2 2 CBOs & CLOs--An Attractive Investment Class, p. 5, Merrill Lynch & Co., Inc., December 1997. Last year the Federal Financial Institutions Examination Council proposed lowering the risk weighting for AAA-rated ABS from 100 percent to 20 percent. Bank investment in AAA-rated ABS products, including CLOs and CBOs, could increase substantially if the proposal is approved. Lower Capital Requirements, Higher Return Ratios Attract Banks to CLO Market On the supply side, issuers of CLOs backed by investment-grade loans are motivated by regulatory capital treatment, return on capital, and relationship management. While the CLOs originated in the late 1980s were designed to purge the lender's balance sheet of lower quality commercial loans, the recent bank-issued CLOs have been secured by higher credit quality, lower margin commercial and industrial loans. A bank that is capital constrained may view the CLO structure as an alternative to issuing additional equity. But more often, banks are motivated to securitize investment-grade commercial loans because by doing so they effectively subject themselves to the market's capital requirements for such loans instead of their regulator's. Tight competition has compressed the margin that banks earn on investment-grade loans to the point that more institutions are considering investment-grade lending to be an inefficient use of capital. As margins have declined, the CLO market has helped relationship managers rationalize lower pricing from the perspective of return on capital. Since investment-grade and noninvestment-grade-performing commercial loans have the same risk weightings for regulatory capital purposes, removing the higher quality, lower yielding assets from the balance sheet tends to leave existing bank capital supporting higher return activities.3 In this way, a bank can improve certain profitability measures, but possibly with a higher risk profile. 3 Pursuant to the Basle Accord, commercial loans generally receive a 100 percent risk weighting regardless of the credit rating of the loan. Proponents of CLOs have argued that banks can improve their risk-adjusted return on capital by removing the higher quality, lower earning commercial loans from the balance sheet. Table 1 illustrates the effects of a CLO on a bank's capital and return ratios. In order to compare the on- and off-balance sheet transactions, the costs of the CLO and the associated reserve requirement are analogized to the on-balance sheet funding costs and capital requirement if the assets remained on the balance sheet. The assumptions reflect the spreads and reserve requirement of a typical transaction. While the execution of the CLO costs more than the on-balance sheet financing of the loans, the risk-adjusted return on capital (RAROC) is greater with the CLO. The reserve requirement is minimized by the tiering of tranches in the securitization, which provides credit enhancement to the senior classes. The reserve fund, if retained by the issuing bank, represents recourse to the bank from the sold assets and requires capital at 100 percent under "low-level" recourse. Table 1 CLOs Can Facilitate a Higher RAROC on Investment-Grade Assets Assumptions: Amount of Loans in CLO: $1 billion Loan Portfolio Yield: Libor + 50 bpts Bank Funding Costs: Libor - 10 bpts CLO Funding Costs: Libor + 24 bpts Bank Retains 1% Reserve Fund: $10 million Before CLO Yield Less Funding Cost (L+50) less (L-10) = 60 basis points Net Spread Earned .006 x $1 billion = $6 million Risk-Based Capital Requirement (8% on $1 billion) = $80 million RAROC $6 million/$80 million = 7.5% After CLO Yield Less Funding Cost (L+50) less (L+24) = 26 basis points Net Spread Earned .0026 x $1 billion = $2.6 million Risk-Based Capital Requirement (100% of Reserve Fund) = $10 million RAROC $2.6 million/$10 million = 26% Source: Bear, Stearns & Co. Inc. CLOs also may be used to facilitate corporate borrowing relationships. For example, banks that want to maintain relationships with corporate borrowers but are restrained by concentration limitations, either by borrower or by industry, may use CLOs to alleviate concentrations without disrupting borrower relationships. Large commercial banks with significant holdings of investment-quality commercial loans are likely candidates to issue CLOs. CLO issuance by investment banks could grow as these institutions secure a stronger foothold in the commercial loan market. In 1997, foreign banks were the primary issuers of CLOs, but more U.S. banks are expected to issue CLOs in the future. Japanese and Asian banks may increase their CLO activity as they come under pressure to improve capital ratios and remove distressed loans from their balance sheets. Arbitrage Opportunities Motivate Most Securitization of Subinvestment-Grade Debt Issuance of CLOs backed by subinvestment-grade loans and most CBOs, which commonly are backed by a mixture of bonds with a subinvestment-grade weighted average, typically is motivated by the potential to capitalize on wide spreads between investment and subinvestment-grade debt. The securities backed by subinvestment-grade collateral, often referred to as "arbitrage" CLOs and CBOs, contain higher yielding, riskier securities such as high-yield debt, distressed bonds, highly leveraged loans, and emerging market debt. By assembling a diversified pool of higher yielding investments, asset managers can limit aggregate event risk and create a security with a lower required yield than the underlying collateral. Securitizations can include a combination of loans and bonds and are sometimes referred to as collateralized debt obligations or CDOs. A Closer Look at CLO Structures While the structures of CLOs and CBOs are similar, banks' involvement as issuers of CLOs, and the forces driving this issuance, elevate the importance of considering CLO structures. Chart 2 presents the basic structure of a CLO. Although specifics may vary, most CLOs use a stand-alone special purpose vehicle (SPV) or trust to purchase a diversified pool of assets from a bank originator or issuer. The purchase of the assets by the SPV is funded through the sale of debt securities to investors. The structure of the SPV may include one or more tranches of debt that are secured by the pool of assets owned by the SPV. The classes of debt are distinguished by their priority of claims on the cash flow from the collateral, with the most subordinated pieces functioning as an equity investment in the pool. Chart 2 The senior tranche is usually the largest, has the greatest amount of credit protection, and earns the highest credit ratings in the CLO structure. The rating of the senior class typically is higher than the average rating of the underlying pool of assets due to the tiering of claims among the debt classes and credit enhancement in the CLO. The junior tranches of debt may be below investment grade or not rated. The reserve or "equity" portion may be retained by the issuing entity as a form of credit enhancement or sold to third-party investors who want a potentially higher return investment. CLO collateral has included both funded and unfunded loan commitments, loan participations, and different types of credit default swaps. Loan assignments also may be transferred through a CLO but are less commonly included because of bank issuers' desire to maintain borrower relationships. The issuer may transfer the actual loan, the cash flow from the loan, or the default risk to investors. CLOs typically rely on an asset manager or servicer to "manage" or protect the investors' interest in the collateral. The investment style or role of the asset manager may change depending on the purpose of the CLO. Securitizations that use an asset manager to actively manage the performance and market value of the collateral are referred to as "market arbitrage" or "market value" transactions. In these deals, the asset manager can trade assets into and out of the securitized pool in order to maximize the market value of the securitized portfolio. In contrast, most bank-issued CLOs are designed as "cash flow" transactions, in which the asset manager's role is more as a servicer than as a portfolio trader. These structures rely primarily on the ability of the collateral to make stable cash flow payments over a predetermined period and emphasize the credit quality of the collateral and the predictability of interest and principal payments rather than liquidity and market performance, as in market value transactions. An Introduction to Delinked and Linked CLO Structures The variables in structuring a CLO are many. The relative size of the senior and subordinated tranches, the form of credit enhancement, the ability of the asset manager or servicer to adjust the asset pool, and the method and degree to which ownership of the underlying loans is conveyed to investors vary among CLOs. Despite the variations, two basic structures have emerged: "delinked" structures and "linked" structures. The primary difference between these two is the extent to which the SPV "owns" the securitized assets. An issuer may consider many factors when determining the type of structure to use, including the ability or desire of the issuer to transfer the loans without notifying the borrower, the credit quality of the loans, the investment rating of the bank issuer, and the desired capital treatment of the securitized loan. In a delinked structure, the collateral is transferred from the issuer to the SPV. Delinked structures are generally treated as "true sales" for accounting purposes, and the loans in the CLO are removed from the issuer's balance sheet. Delinked CLOs are structured to insulate the investor from the credit quality problems or insolvency of the issuer. Ratings on delinked CLOs are predicated on the projected performance of the collateral and the credit enhancement structure rather than the credit quality of the issuer. Some delinked CLOs are similar to structures used in credit card securitizations that capitalize on the flexibility of a revolving master trust. The master trust structure is advantageous because it allows for the securitization of different types of assets, such as fixed or floating rate or revolving or term loans. In linked transactions, also known as credit linked notes, the issuer retains ownership of the underlying collateral, and the cash flow generated by the collateral pool is conveyed or sold to the SPV. All or part of the credit risk from the underlying assets is transferred to the CLO investor using credit derivatives. As in delinked CLO structures, credit protection is provided through the layering or tranching of the debt sold and other credit enhancements. Investors in linked CLOs are not completely insulated from the credit risk of the issuer. Because the issuer retains ownership of the underlying loans, a default or bankruptcy by the issuer could affect the transmission of cash flow to the CLO investors. As a result, investors in linked CLOs bear both the credit risk of the securitized loan pool and, to some degree, the risk that the issuer may become insolvent. Because of this dual exposure, ratings on linked structures are typically capped by the credit rating of the issuer. The accounting and regulatory capital treatments of delinked and linked CLOs also differ. Linked structures generally do not qualify for sale treatment under generally accepted accounting principles because the assets remain under the control of the issuer. Issuers of linked CLOs may be granted some regulatory capital relief under the Basle Accord if the cash received from the securitization is assigned as collateral for the underlying loans. The Basle Accord, which governs capital adequacy requirements for Bank for International Settlements member countries, reduces the risk weighting on commercial loans that are secured by cash or certain types of risk-free marketable securities such as Treasury bills.4 While linked CLOs may provide some form of capital incentive for foreign banks under the Basle Accord, linked structures offer little relief to U.S. banks because U.S. banks must maintain minimum leverage capital ratios in addition to risk-based capital ratios. Since the securitized loans count as assets of the bank issuer in a linked structure, the leverage ratio (roughly, book equity to book assets) is not reduced. Consequently, the linked CLO structure has been more popular among foreign banks. 4 Under the Basle Accord and the U.S. risked-based capital guidelines, assets collateralized by cash or Treasury securities generally receive a preferential risk-weighting that may range from 0 to 20 percent. For background information regarding the risk weightings for collateralized transactions applicable to federally regulated institutions, see Federal Deposit Insurance Corporation Financial Institution Letter number 64-96 dated August 22, 1996. The Role of Investment Rating Agencies Although the approach may vary among rating agencies, the criteria used to determine the investment rating for CLOs are similar. Rating agencies evaluate the ability of the securitization vehicle to make interest and principal payments to holders of the debt. This analysis requires an evaluation of the credit quality of the underlying collateral pool, including the projected cash flow generated by the pool, the credit enhancement, and any additional protection provided to the investors based on the structure of the securitization. The rating agencies set limits on the amount of industry and borrower concentration in a pool and statistically evaluate the effect of diversification among loans when estimating potential defaults and losses from the securitized assets over the life of the transaction. If the underlying collateral is not already rated--most commercial loans are not--the rating agency will grade the underlying loans and assign a rating to the security on the basis of the credit quality of the loans and the underwriting criteria used by the lender. Estimates of default probabilities, timing of default, and recoveries in the event of default are assigned to the loans and vary by collateral type and credit grade. These estimates are generally based on historical default studies authored by the various rating agencies. Implications for Insured Institutions The advent of CLOs poses new opportunities and risks to banks. The ability to transfer all or part of a commercial loan's credit risk to investors may have several consequences. When issuers of CLOs securitize their highest grade assets, they are effectively lowering the weighted average credit quality of their retained assets. An institution's loan loss reserving policies and capital adequacy should take into account the implications of its CLO strategy. While the issuance of CLOs may be confined to larger banks that have considerable commercial loan portfolios, smaller banks or other types of institutions that desire a greater exposure to this type of lending may consider investing in CLOs. These instruments offer banks the opportunity to invest in a diversified pool of commercial loans. Because of credit enhancement features and diversification advantages, the most senior debt issued by the CLOs can earn a higher investment rating than the average rating on individual loans in the pool. Despite the investment rating, banks that invest in CLOs should be aware that CLO structures are less standardized than other ABS investments, and therefore, performance and underlying risk will be both issuer and deal specific. Kathy Kalser, Chief, Financial Sector Analysis Section Allen Puwalski, Senior Financial Analyst Regional Outlook Information Return to Regional Outlook main page