Collateralized loan obligation holdings at U.S. banks dipped slightly in the first quarter to just under $99 billion, compared to $99.5 billion as of the end of the fourth quarter of 2019, according to bank regulatory filings with the Federal Reserve System.

JPMorgan Chase & Co. is again the largest holder of CLO securities as of March 31, growing its total holdings to just under $34 billion in the first quarter, compared to $29.8 billion at the end of 2019.

Wells Fargo & Co.'s CLO security holdings shrank by $4.5 billion over the quarter to $24.6 billion, although the bank did disclose in a recent SEC filing that it grew its holdings of CLOs in loan form to $7.7 billion as of March 31, compared to $7 billion as of Dec. 31, 2019. Combined with security holdings, that puts Wells' total CLO exposure at close to $32.3 billion.

CLOs held in loan form are classified differently for regulatory purposes than CLOs held as securities and are not represented as structured financial products backed by corporate loans in Y-9C filings with the Federal Reserve System.

Citigroup Inc. modestly expanded its holdings by just over $50 million during the first quarter, to $21.4 billion.

Those three banks account for just under $80 billion of CLO exposure inside the banking system, or 81% of the approximately $99 billion of CLOs held by U.S. banks. That proportion is unchanged relative to the end of 2019.

Do CLOs pose a systemic risk to the banking sector due to COVID-19?

In light of the global economic slowdown unleashed by COVID-19, there have been substantial concerns from economists, policymakers and investors that high leverage among speculative-grade U.S. corporates may amplify the medium-term economic pain that the pandemic will cause.

In particular, the steep loss of revenue tied to COVID-19 lockdowns has made debt burdens for some companies unsustainable, resulting in a number of loan forbearances and amendments, and in more serious cases, distressed exchanges and bankruptcies. These scenarios all imply distress and losses for the loans in CLOs and, potentially, for the banks with exposure to them in securitized form.

While the default rate is expected to go up, CLO holdings on bank balance sheets appear unlikely to see major impairments because of defaults — at least for now.

U.S. banks typically hold the senior-most debt in a CLO vehicle, and as the loans in a CLO portfolio undergo a sufficient degree of distress, interest payments meant for junior debtholders are rerouted to pay down senior investors even faster than is typically the case.

"Risk to AAA CLO holdings, which are primarily what banks hold, seems relatively low. ... 58% of underlying leveraged loans would need to cumulatively default before they see losses of principal," assuming a recovery rate of 40%, wrote Vivek Juneja, large-cap bank analyst at JPMorgan, in a June 24 note. Juneja also noted that default rates would need to remain at a constant of 29% over the life of a CLO to see impairments at the AAA level, also assuming a 40% recovery rate.

Luckily, no one expects the economic slowdown caused by COVID-19 to be so severe — again, that is, for now. Bank desks are predicting a default rate for leveraged loans to just below 10% by the end of this year, while S&P Global Ratings recently forecast that the U.S. trailing-12-month speculative-grade corporate default rate will likely increase to 12.5% by March 2021; under a more pessimistic scenario, it foresees the default rate jumping to 15.5% "on the back of a possible resumption of COVID-19 cases later this year or early next ... [which] could further complicate this scenario."

Likewise, expected recovery rates from impaired loans remain low, but not low enough as to imply CLO losses at the AAA level. For example, Moody's recently lowered its recovery expectation for first-lien loans again to 58% for companies with private equity sponsors and 62% for those without. While those are still substantially lower than the realized historical recovery average of 75% and 78%, they are not so low as to imply bank balance sheet impairments at the AAA level, based on the previously cited forecast of a 58% cumulative default rate with a 40% recovery rate. The former levels may cause losses elsewhere in the CLO capital structure but not likely to the senior debt on bank balance sheets.

Still, the macroeconomic outlook remains highly uncertain. These forecasts could change in a matter of weeks, for better or for worse. Expected default rates and recoveries from impaired loans are still only forecasts and may change based on a strengthening or worsening economic picture. So while CLOs are still a long way off from impairing bank balance sheets, it is equally as true that they are much closer to doing so today than they were just three months ago.

This S&P Global Market Intelligence news article may contain information about credit ratings issued by S&P Global Ratings. Descriptions in this news article were not prepared by S&P Global Ratings.