The Financial Stability Oversight Council (FSOC) may lack the tools it needs to understand and manage risks related to leveraged lending and collateralized loan obligations (CLOs), according to a team at the U.S. Government Accountability Office.
The team prepared the report because of some observers’ concerns that the popularity of leveraged lending and CLOs could pose a threat to the stability of the financial system, Michael Clements, a GAO director, writes in a report summarizing the team’s findings.
The FSOC was established by Dodd-Frank legislation and brings together federal agencies, state insurance regulators and an independent insurance expert appointed by the president.
Leveraged Loans and CLOs
A leveraged loan is a loan made to a company with poor credit and a high ratio of debt to earnings.
Banks, mutual funds, life insurers and other institutional investors may invest in leveraged loans directly.
In other cases, leveraged loans may flow into CLOs, and institutional investors or retail investors may end up investing in the CLOs.
The size of the market for institutional leveraged loans has increased from $500 billion in 2010 to $1.2 trillion in 2019, according to GAO estimates.
The GAO had to use four different sources to come up with estimates of what types of investors have much invested in CLOs.
U.S. life insurers own about $129 billion of the $611 billion in CLOs, banks hold $85 billion in CLO investments, and investment funds registered with U.S. securities regulators hold about $56 billion in CLO investments, according to the GAO.
Although banks, life insurers and registered funds have about $270 billion in CLO investments, that amount is small relative to those investors’ asset base, according to Clements.
The GAO’s Perspective
Most financial services regulators have concluded that leveraged lending poses little threat to financial system stability, but FSOC has assessed the possible threat mainly by looking at existing data and reports, Clements writes in a report on the GAO team’s findings.
FSOC monitors potential threats to the financial system and coordinates the country’s response to potential threats — should be bringing regulators and people from the private sector in for emergency scenario simulations, to see how players in the CLO market might act in crisis, Clements writes.
The Conference of Federal Reserve Bank Presidents, for example, has already participated in two leveraged loan market crisis simulations, according to Clements.
CLO market crisis simulations could give FSOC a better understanding of its limitations, and what it could do in a real crisis in spite of those limitations, Clements says.
That kind of knowledge could be especially important for FSOC, “given that the mission to respond to risks was given to FSOC but the authorities to act are fragmented among multiple financial regulators,” Clements says.
Clements says one important gap in FSOC’s toolbox is a lack of the ability to make binding recommendations to other state or federal agencies about how to monitor and control what looks like a risky activity.
FSOC can designate a specific company as one that is important to the financial system and in need of extra regulatory attention, but it can’t designate a potentially risky activity as being in need of extra attention, Clements says.
“For example, if the actions of a large group of different types of investors in nonbank leveraged loans or CLO securities were found to be a significant threat to financial stability, FSOC could try to designate each of the nonbanks in the group individually,” Clements says.
“Assuming each met the statutory standards for designation (and any additional conditions imposed by FSOC), the Federal Reserve would impose enhanced prudential standards on the entities. However, this would be a difficult and time-consuming process that likely would require FSOC to consider each nonbank individually,” he explains.
If FSOC could designate activities as systemically important and risky, it might have an easier time justifying the need for extra oversight, and it might have an easier time getting regulatory agencies other than the Federal Reserve to help provide the extra oversight, Clements says.
— Read A New Way to Hedge CLO Risk Is Here. It’s More CLOs., on ThinkAdvisor.