“Canary in the Coal Mine” On ECC Earnings Call?
[This article was first published with our Inside the Income Factory® members on March 29.]
One of our members asked me if I’d seen the comment by Tom Majewski, CEO of Eagle Point Credit (NYSE:ECC) during the fund’s recent earnings call on February 22. I listened in on the call, and even asked a question at the end of the call about the CLO expiration and wind-down process, and how that impacts ECC’s own durability and longevity. But I didn’t recall the specific comment that our member raised.
In reviewing the transcript of the call, I see that Tom had said, fairly early in the call: “Notably, during the quarter, we deployed a bit of capital into SRT or significant risk transfer investments. These are bank balance sheet securitizations where banks seek to obtain capital relief on diversified pools of core lending assets. They’re sometimes called balance sheet CLOs, and we believe they do present an attractive investment opportunity.”
Looking back, it may seem ironic, but in retrospect not surprising, that some banks were turning to the CLO (i.e. “collateralized loan obligation”) market and to CLO funds like ECC, to get risk assets (i.e. loans) off their books last year. If market watchers and analysts had been more astute, perhaps some would have seen this as a “canary in the coal mine” in signaling potential problems developing in the banking sector.
From our perspective, it is just another sign of the opportunistic nature of some of our fund managers, like the ECC team, who have told us on several occasions that volatile times are when CLOs, hedge funds and other sophisticated investors can often find the best opportunities in the credit markets.
I find it interesting, and not surprising, that banks would use CLOs created with loans from their own balance sheets to lessen their own leverage and essentially free up capital. I remember, as a financial journalist in the early 1990s, writing about some of the forerunners to CLOs, which were called collateralized bond obligations (CBOs), and were created by insurance companies as a way to lessen capital requirements. The insurance companies could sell $100 million of their non-investment grade corporate bonds and private placements into a CBO, place the top $90 million debt tranches with outside investors, keep most of the profit (and the risk) in the bottom $10 million (i.e. the “equity” of the CBO) on their own books, and reduce the capital reserves they had to maintain by 90%. When I wrote an article explaining the whole thing in simplified detail, one of the insurance executives told me, with a certain amount of chagrin, “You got it exactly right… but we wish you hadn’t.” (Note that both CLOs and CBOs have performed well over the past three decades for investors and neither of them should ever be confused with the “CDOs” (collateralized debt obligations) that held poorly and sometimes fraudulently underwritten sub-prime home mortgages and home equity loans and helped precipitate the 2008/2009 financial crash.)
Real Banks and “Virtual Banks”
It is also a good time to remind ourselves of the differences between real banks and “virtual banks,” which is how I often describe CLOs. While CLOs may seem more complex and strange to many of us investors when we first confront them, they are actually less risky in some respects than real banks. Both real banks and CLOs are leveraged about 10 to 1, and they both make loans (although CLOs specialize in secured corporate loans, while real commercial banks may make a broader assortment of different types of loans).
So they both have to worry about credit risk: defaults, and the loss that follows defaults; although losses on secured loans (the kinds CLOs hold) are mitigated by the impact of collateral, which generally allows lenders to recover 60-70% or so of their principal. So a 5% default rate only results in a 2% rate of loss, if the secured lender recovers 60% of its principal on any loans that default (resulting in 40% losses on the 5% of loans that default, which equals net loan losses of 2%; i.e. 40% X 5% = 2%). That’s the beauty of collateral.
The most significant difference between real banks and CLOs is on the liability side of the balance sheet. Real banks have most of their liabilities in deposits, that can be called without notice by their owners and walk out the door (or be electronically transferred out in nanoseconds), leaving the banks subject to the very real risk of the proverbial “run on the bank.” We don’t see bank runs often, but when we do, like in the recent Silicon Valley Bank, they can destroy a bank (or if not quickly addressed and brought under control by bank regulators) an entire banking system, within days.
CLOs have term debt, which while generally floating rate (i.e. no interest rate risk), has maturities that are largely co-extensive with the life of the CLO (i.e. specific ramp-up, re-investment, non-call, and repayment periods that may extend for 5 to 10 years in various cases). So there is little chance of a run on the CLO like there is on a bank, although serious drops in loan prices or cash flow can cause an acceleration of payments to certain classes of debt. But in general, a CLO’s liabilities are much more stable and manageable than those of a commercial bank.
Some of this may seem a bit like “inside baseball” stuff for investors who want to stick with somewhat simpler asset classes like stocks, loan and bonds. But I know there are many of us who appreciate and even enjoy the greater complexity and risk/reward challenges of CLOs and the funds that own them. So this additional background and historical “color” may be of interest.
As always, I look forward to your questions and comments.
Steve
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