Brexit, FRTB and worries about CLOs

The week on, December 8-14, 2018

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HM Treasury’s Brexit surprise

Statutory instruments throw up unwieldy divergence in Mifid II and Emir rules

EU lawmakers delay FRTB capital charges

Leaked papers potentially push market risk capital charges beyond Basel’s 2022 deadline

CLO scare: could rated tranches see losses?

The structures are more solid, but the loans are dicier, and recovery rates may be disintegrating


COMMENTARY: Reasons to be careful

The first warning sign is how well things seem to be going. Too many frauds and risk management failures over the past decade or so have been preceded by reports of unprecedentedly good performance. Only when it is too late do investors realise the reports were false, or concealed crippling tail risks, or that the expansion in sales represented the product being sold far beyond its intended customer base.

The market for collateralised loan obligations (CLOs), though not fraudulent, has been growing rapidly – it doubled between 2013 and 2017, and is set for a new issuance record this year. Alarm bells are now, perhaps belatedly, ringing.

This week, looked at the possible downsides of CLOs. The equity tranches of these products are highly volatile, and their performance is complex and idiosyncratic enough to make them very difficult to hedge. Reassurances that CLO equity tranches performed very well in the 2008 crisis are not as comforting as they could be. Much has changed in the loan market since then, and another crisis could burn through equity tranches altogether, leaving holders of at least some of the higher tranches facing losses as well. The median CLO issued since 2014 would survive with its rated tranches untouched, we are told – but that’s just another way of saying half of all issued CLOs would not.

That in itself would not be catastrophic, but the problem is that if a downturn causes CLO investors to flee, defaults could snowball. Too many corporate borrowers have been relying on the deep CLO market to keep rolling over their sub-investment grade debt, and if CLO issuance dries up they risk default. An initial situation that was bad but containable could become a system-wide crisis – just as it did 10 years ago. The mantra “This Time Is Different” was wrong in 2008; it would be risky to assume that this time is, well, any different.



The aggregate effective notional amount of credit protection sold by the eight US global systemically important banks fell by $1.9 trillion (41%) to $2.8 trillion at the end of the third quarter of 2018, from two years ago



“[The Current Expected Credit Loss standard] will not be countercyclical, it will simply be less procyclical than the current incurred loss accounting standard, which is highly procyclical. [The current standard] opens the floodgates during the boom times and restricts credit during the bad times. That’s what CECL is trying to correct” – Mark Zandi, Moody’s

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