Why Banks are Big Buyers of CLOs — And Why They May Slow Down

It's well known that banks are big buyers of collateralized loan obligations, but a report published last week by SNL Financial sheds some light on the appeal of these structured products to lenders.

In some cases, it's not just the attractive yield or familiarity with the asset class, but a desire for exposure to the commercial loans backing these securities. However, banks may start putting on the brakes thanks to new deposit insurance assessment rules that treat CLOs as high-risk assets.

Banking industry holdings of collateralized loan obligations have risen sharply in the wake of the financial crisis. Banks and thrifts have increased CLO balances by close to 135% from the first quarter of 2010 to the first quarter of 2013, according to SNL. CLO holdings as a percentage of banks' total securities have climbed more than 75% over the same period.

First Niagara Financial Group (FNFG) has increased its holding as part of its acquisition strategy when it purchased 195 HSBC USA branches, Chief Financial Officer Gregory Norwood told SNL. "Since we didn't buy a lot of loans with that acquisition, we wanted to buy credit assets that began to mimic the assets we would have bought," he said.

First Niagara's CLO balance jumped to nearly $1.6 billion, or 13.14% of the bank's total securities, in the first quarter, compared with $800.1 million, or 5.52% of total securities, a year earlier.

The Buffalo, N.Y., company does not plan to continue upping its CLO balance. "We basically have the book we want and it will amortize down over time and loans will grow, and you'll see that balance sheet rotation from securities into loans," he told SNL.

First Niagara is one of several companies that have ramped up their CLO balances in recent quarters. According to SNL data, 21 of the 28 U.S. banks and thrifts that held CLOs at March 31 have increased their CLO holdings since the first quarter of 2012.

At Goldman Sachs Group (GS), for example, CLO holdings rose to $949 million at March 31, compared with $279 million in the first quarter of 2012. Morgan Stanley (MS) increased its CLO balance to $67 million at March 31, from no holdings in the prior-year period. JPMorgan Chase (JPM), Wells Fargo (WFC), Citigroup (NYSE:C) and Bank of America (BAC) also increased their CLO balances since the first quarter of 2012.

It's not just big banks that have added to their holdings. After holding no CLOs in the fourth quarter of 2012, Fieldpoint Private Bank & Trust in Greenwich, Conn., had $20.3 million at CLOs, or 10.87% of total securities, at March 31.

Bill Kennedy, chief investment officer at Fieldpoint Private, said the numbers reflect a concerted effort to manage risk in its portfolio. "The management team worked last year to try to find opportunities where we could reduce our interest rate risk and our duration risk, and take a little bit more credit risk and liquidity risk in the portfolio," Kennedy told SNL. He said duration risk posed an increasing threat in summer 2012, driving the company out of long-dated paper like Treasurys.

Securities issued by CLOs are floating rate like the syndicated loans used as collateral. "We thought: Here's an opportunity to pick up some yield at a floating-rate instrument and shift that risk exposure away from duration to more of the credit side," Kenneda said.

Like First Niagara, Fieldpoint Private will not necessarily continue to increase its CLO holdings. Though 2013 has been a robust year for CLOs, Kennedy said, "that's not always a good sign. The issuance [tends to] go wherever the capital is available. The deeper the new issuance market becomes, the harder it is to identify the really good credits, those diamonds in the rough."

Kennedy also noted that spreads have been tightening. "Spreads on everything have contracted …CLOs to boot," he said. "As we got into the first quarter of this year, and even this quarter, we've seen that stretch for yield accelerate."

There is another reason for banks to ease back on CLO growth: a change in deposit insurance rules that took effect on April 1. Assets now factor heavily into calculations of deposit-insurance premiums, and the rules require higher assessments for even the least risky CLO tranche, those rated 'AAA.'

Assessment rates used to be multiplied by a bank's total domestic deposits. However, the Dodd-Frank Act required the FDIC to change that basis to assets minus capital — essentially, a bank's liabilities. The FDIC rules use a "scorecard methodology" to determine the assessment rates it would charge big and highly complex depository institutions.

The rules apply to loans and CLOs issued on or after April 1. Those issued before that date are grandfathered.

This story originally appeared on leveragedfinancenews.com.