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Hedge Funds Expose Banks to Heightened CLO Risk, BIS Says

Marianna Aragao

(Bloomberg) -- Banks may be indirectly exposed to collateralized loan obligations if the hedge funds they have relationships with suffer losses on their holdings, the Bank for International Settlements said.

As providers of services such as prime brokerage to major investors in CLOs, banks may face larger losses than those implied by their direct exposures, creating heightened financial stress, the BIS said in its quarterly review. The opacity of such links may represent a source of instability similar to financial institutions’ off-balance sheet exposure to the collateralized debt obligations (CDOs) that were at the center of the financial crisis, the BIS added.

In the report released on Sunday, the Basel-based institution also warned about concentration and liquidity risks in CLOs, as well as potential ripple effects in the market.

“Some investment funds offering daily redemption of shares hold a small share of their assets in CLOs. At times of market distress, investors may rush to redeem their shares, quickly depleting the liquidity buffers held by such funds,” BIS analysts wrote.

“This rush could result in fire sales and large price volatility, imposing mark-to-market losses on other intermediaries.”

Rapid Growth

Demand for CLOs -- bundles of loans to corporate borrowers that are repackaged as bonds rated according to their risk of default -- has surged in recent years as investors seek higher-yielding assets, which has helped prop up the supply of leveraged loans they’re made up of.

The rapid growth has drawn attention from regulators including the Federal Reserve and the European Central Bank, which have compared some aspects of the growth in CLOs to the mortgage industry in the run-up to the sub-prime crisis.

Read more: Regulators Alarmed by Risky Loans, But Don’t Know Who Holds Them

While CLOs are less complex and their collateral is more diversified than pre-crisis CDOs, the BIS review points to some similiarities between the two: deteriorating credit quality of underlying assets, opacity of indirect exposures and high concentration of banks’ direct holdings.

The BIS estimates that banks directly held at least $250 billion of CLOs in 2018. The leveraged lending market is estimated at $1.4 trillion outstanding, of which about $200 billion is denominated in euros, and the rest in U.S. dollars.

Despite the risk of indirect exposures, banks hold mostly AAA-rated tranches of CLOs, which didn’t suffer a default before, during or since the financial crisis.

To contact the reporter on this story: Marianna Aragao in London at mduartedeara@bloomberg.net

To contact the editors responsible for this story: Vivianne Rodrigues at vrodrigues3@bloomberg.net, Charles Daly, Chris Vellacott

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