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Risk of CLO Losses Keeps Japan’s Banking Regulator on Alert

Risk of CLO Losses Keeps Japan’s Banking Regulator on Alert

(Bloomberg) -- Japan’s financial regulator is closely watching global credit markets for renewed signs of stress because there’s no guarantee that support measures will keep borrowers afloat during the pandemic, officials said.

Efforts in the U.S. and elsewhere have so far staved off a potential implosion of securities like collateralized loan obligations, which are favored by yield-starved Japanese banks. Still, the Financial Services Agency remains concerned about risks including the possibility of downgrades to the highest-rated products, the officials said, asking not to be identified in accordance with its policy.

Some Japanese lenders booked billions of dollars in paper losses on their holdings of CLOs -- packages of leveraged loans to highly indebted U.S. and European companies -- during last quarter’s market turmoil. Credit markets have since rebounded, after the U.S. Federal Reserve took steps to support the economy including buying corporate debt.

The top-rated portions of CLOs are relatively robust, one of the FSA officials said, citing the fact that they didn’t default during the 2008 global financial crisis. Still, while leveraged borrowers are currently obtaining financial support, it’s uncertain whether they can continue to avoid bankruptcy if the outbreak persists, they added.

Risk of CLO Losses Keeps Japan’s Banking Regulator on Alert

Moody’s Investors Service put hundreds of CLOs on review for downgrade last month, though it excluded AAA rated tranches.

Whether the highest-rated securities eventually get cut “depends on how bad the real economy becomes,” said Tomohiro Miyasaka, chief securitization analyst at SMBC Nikko Securities Inc. in Tokyo. “It could become more likely if the economy gets worse.”

Authorities in Japan have been growing increasingly concerned about financial institutions’ exposure to CLOs. Prices could fall as much as 30% should top-rated bonds be downgraded to AA or A at a time of market stress, the Bank of Japan said in a report last October. Rating cuts may also lead to higher capital charges for banks because lower-rated securities would carry a higher risk weighting.

Five major Japanese banks held a combined 13.6 trillion yen ($126 billion) of CLOs as of March 31, disclosures show. The biggest investor, Norinchukin Bank, pledged to keep cutting back on purchases this week after booking a 400 billion yen paper loss on the products last quarter. By contrast, Japan Post Bank Co. said it plans to add to its holdings even after logging an unrealized loss of 121.9 billion yen.

Lenders have so far been insulated from CLO price drops because they focus on holding top-rated debt until it matures and don’t need to realize losses until the value of the securities falls by 50%. AAA rated CLOs touched 92 cents on the dollar in March and have since recovered to trade at almost 98 cents, according to a Palmer Square index.

©2020 Bloomberg L.P.