Banks, insurers could face unexpectedly big CLO losses, Bank for International Settlements paper says

Banks, insurers and hedge funds could face unexpectedly large losses in a prolonged downturn from their holdings of securitized notes of high-risk loans to troubled companies, Bank for International Settlements researchers said.

These notes, or collateralized loan obligations, invest in pools of high-interest loans to companies with significant debt that now face a “higher likelihood of clustered defaults,” the paper last week said.

“The economic disruption caused by the pandemic, if protracted, could pose significant challenges for some structured finance products, in particular collateralized loan obligations,” said the paper by Sirio Aramonte and Fernando Avalos.

One section of the paper is titled, “A perfect storm for CLOs?”

— Leveraged loans, CLOs —

CLOs are complex instruments that are part of the less regulated, rapidly growing shadow-banking sector, bank regulators say. Little reliable data exists for these investments, which are said to pose financial stability risks.

Securitized CLO notes are bundles of “leveraged loans” from bank syndicates to heavily indebted companies.

These loans are often purchased and pooled by hedge funds, private equity funds and other nonbanks. CLOs issue notes of different seniority against the cash flows of the pool.

— AAA tranches —

Among note holders, banks and insurers often invest in AAA-rated tranches. They are normally considered safe because more junior tranches offer loss-absorbing buffers. These junior tranches are usually held by hedge funds and other institutional investors.

But the broad harm inflicted by the pandemic is causing a re-evaluation of traditional notions of risk among tranches, the researchers said.

“In the event of a prolonged economic slowdown, CLOs could suffer high losses,” the paper said. “The economic damage induced by the pandemic could be widespread enough to potentially upend” the patterns of losses among tranches.

Insurers, which hold large amounts of senior mezzanine notes, just below AAA, could have difficulty offsetting cash-flow shortfalls generated by capital and income losses, the paper said.