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.