Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Monday, July 15, 2019

Gerding on Securitization

Erik F. Gerding has posted Testimony of Erik F. Gerding Before the U.S. House of Representatives Subcommittee on Consumer Protection and Financial Institutions on 'Emerging Threats to Stability: Considering the Systemic Risk of Leveraged Lending' on SSRN with the following abstract:

Risk is building in the leveraged loan and collateralized loan obligation (“CLO”) markets. These two markets are connected: leveraged loans are being repackaged into CLOs just as mortgages and mortgage-backed securities were used to create collateralized debt obligations (“CDOs”), the financial products at the heart of the financial crisis 11 years ago.

There are important differences but also troubling parallels between the leveraged loan/CLO markets and the earlier mortgage/CDO markets.

One alarming similarity is the decline in leveraged loan underwriting standards: the market is now dominated by “covenant-lite loans.” Covenant-lite loans permit greater leverage by borrowers and remove an early warning system for lenders.

Purchases of CLOs by banks and other regulated financial institutions made in order to game crucial regulatory capital requirements (“regulatory capital arbitrage”) remain a significant concern
Like mortgages and CDOs, leveraged loans and CLOs form a pipeline or system. Disruptions at either end of the system can cause financial havoc on the other end and then ricochet back. This is akin to a coiled spring or “crisis accordion.”

Losses or disruptions in the leveraged loan/CLO markets, even if they do not approach the levels of mortgages/CDOs in the global financial crisis could still be significant, e.g., amplifying a recession. We should be humble about our ability to predict the upper bound of financial market disruptions or crises.

Some tranches of CLO securities appear not to trade actively. Many CLO securities trade on opaque markets lacking transparent prices. A lack of trading of CLO securities undermines the economic rationale of these securities, as well as their safety and favorable regulatory treatment. A lack of transparent prices means that neither the marketplace nor regulators can rely on prices to police risk-taking in the CLO market.

Regulators must monitor and analyze data on leveraged loans and CLO markets. The OFR needs cooperation from other financial regulators in assessing risk in these markets. Lack of data sharing among financial regulators remains a crucial weakness. The OFR needs an independent source of funding. Regulators need minimum standards in their examinations with respect to assessing bank exposure to leveraged loans.
I also recommend:

- Stress testing of financial markets, not just individual institutions;
- Requiring financial regulators to conduct war games to prepare for market disruptions;
- Underscoring that the burden is on financial institutions to prove that leveraged loans and CLOs are safe rather than on regulators to prove that they are unsafe.

If data gathering reveals significant systemic risk in leveraged lending/CLO markets, regulators should use a mix of tools, including limiting bank investments in CLOs, enhanced and countercyclical capital requirements, and the Volcker Rule “covered funds” provisions.

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