January 14, 2021 - In fall 2019, the Government Accountability Office (“GAO”), launched a study into whether leveraged lending posed systemic risks. The timing was remarkable as, just a few months later, Covid-19 came to U.S. shores. The pandemic was the most severe test of the loan market since the Financial Crisis, providing a timely (if unfortunate) case study of loans in a stress situation. The result? The GAO reported that, “[a]gencies have not found leveraged lending to significantly threaten stability”, albeit with the caveat that the agencies “remain cautious amid pandemic”. We discuss the key findings of the 80-plus-page report below – in the GAO’s words (and with page references so readers can review the original source themselves!).

The GAO laid out their conclusions upfront, even before the Table of Contents:

• “Based on regulators’ assessments, leveraged lending activities had not contributed significantly to the distress of any large financial entity whose failure could threaten financial stability. Large banks’ strong capital positions have allowed them to manage their leveraged lending exposures, and the exposure of insurers and other investors also appeared manageable.”
• “Mutual funds experienced redemptions by investors but were able to meet them in part by selling leveraged loan holdings. While this may have put downward pressure on already-distressed loan prices, based on regulators’ assessments, distressed leveraged loan prices did not pose a potential threat to financial stability.”
• “Present-day CLO securities appear to pose less of a risk to financial stability than did similar securities during the 2007–2009 financial crisis, according to regulators and market participants. For example, CLO securities have better investor protections, are more insulated from market swings, and are not widely tied to other risky, complex instruments.”

Now, into the weeds of the report! After sizing the market, the GAO turned to the Covid-19 Crisis, noting that, “leveraged loan and CLO markets were negatively affected by the COVID-19 shock. The subsequent measures taken to contain the pandemic effectively closed some sectors of the economy starting in mid-March 2020. Widespread business closures aimed at decreasing the spread of the virus led to immediate and growing losses in revenue and difficulties in servicing debt, including for leveraged loans, particularly in consumer-facing industries like airlines, nonessential retail, and hotels.” (p. 29.)

On page 30 GAO discussed market reaction to the pandemic, observing that:

• Leveraged lending halted in March, then slowly recovered.
• Loan prices declined substantially in March, and more than half of the loan market was priced at distressed levels, which may have exacerbated fire sales. Prices began to stabilize in April and had largely stabilized in September.
• Leveraged loan downgrades hit record levels and defaults increased substantially.

So how did these shocks affect CLOs? According to p. 31, while “[t]he credit profiles of CLO leveraged loan collateral deteriorated after the COVID-19 shock, resulting in negative credit rating actions for many non senior CLO securities senior CLO security tranches remained largely resilient to the turmoil in the leveraged loan market.” (See the COW, which shows how loan secondary prices and CLO issuance mirrored each other through the downturn and recovery.)

The GAO then turned to how Covid-19 affected institutions that lend or buy CLO securities. The news, starting on p. 33, was reassuring: “Based on regulators’ assessments as of September 30, 2020, exposure to leveraged lending has not contributed significantly to the distress of any large, potentially systemically important bank, insurance company, or other financial entity.”

On the banking side:

• Banks “were able to absorb the increased draws on credit lines.”
• “[L]everaged lending losses had not been big enough to put downward pressure on banks’ creditworthiness, and they had not negatively impacted banks’ ability to access credit markets as of September 30, 2020.”
• Stress tests “which included a severely adverse scenario with disruptions in the leveraged loan and CLO markets, concluded that banks would experience substantial losses under this scenario but could continue lending to businesses and households.”

Insurance company exposures to loans likewise did not generate undue risk as “NAIC staff told us that they did not believe that U.S. insurers’ leveraged loan or CLO security holdings were likely to be large enough to cause disruptions to the industry or the wider economy, as of September 30, 2020.” (p. 35.)

On the loan mutual fund side (p. 37), the NAIC observed that, “post COVID-19 shock asset sales from mutual funds that invest primarily in leveraged loans may have contributed to downward pressure on loan prices in an already declining market but had not posed a significant threat to financial stability as of September 30, 2020.”

In sum, loans and CLOs faced the ultimate stress test in the form of the pandemic, and the GAO report supports the view that systemic risks fears have been overblown.