Commerz tags €5bn of CLOs as hard-to-value

When structured credit markets froze up in March, Commerzbank could not find enough real quotes to accurately price its collateralised loan obligations (CLOs). The dearth forced it to shift €4.8 billion worth ($5.2 billion) into the mark-to-model category – reserved for complex, illiquid assets.

The move increased the German lender’s stock of Level 3 assets by 69% quarter-on-quarter to €9.8 billion. As of end-March, they made up 7.2% of all fair value assets, up from 5% at end-2019.

Level 3 is a catch-all category for assets with fair values that are based on banks’ own assumptions because market inputs are lacking.

 

Commerzbank said primary CLO issuances halted in March and secondary market liquidity dried up as buyers went on strike, meaning its holdings couldn’t be fairly priced under Level 1 or 2 standards. The bank disclosed €5.7 billion of structured credit exposures as of end-March.

Prior to last quarter, the firm had shrunk its Level 3 assets from a recent peak in Q1 2018, when they totalled €10.4 billion, to €5.8 billion. Many European Union lenders saw Level 3 inventories spike in early 2018 following the roll-out of the IFRS 9 accounting standard, which triggered a mass reclassification of assets previously booked at amortised cost into fair value.

What is it?

Financial assets are typically valued at either fair value or amortised cost in banks’ accounts. Fair value assets are priced at their estimated potential market price.

Those calculated in reference to actual quoted prices are designated Level 1, those to other observable inputs Level 2, and those to unobservable inputs Level 3.    

Why it matters

By designating its CLOs as Level 3, Commerzbank is relying on its valuation models to price the assets, and betting on investors and regulators to trust in the accuracy of its estimates.

The long-running concern with Level 3 assets is that banks do not mark them down sufficiently when markets dry up, artificially inflating them beyond reason. This may not be a problem if a bank is able to hold onto its assets for the long-term. But if forced to sell, a Level 3 asset may not fetch the modelled price, inflicting painful losses.

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