The Stalled CLO Market: Implications for Finance and The Real Economy

As hopes for a thriving Wall Street fade, Federal Reserve Chair Jay Powell's reluctance to pivot has left finance packages languishing. The freeze poses a significant threat to the Collateralized Loan Obligation (CLO) business, which flourished on the back of cheap money by bundling loans and marketing them as bonds.

Over the past decade, bankers transformed CLOs from specialized securities into a cornerstone of capital markets and a red-hot financing product. However, the sector now faces contraction due to a stagnant M&A market and a shortage of credit. Major US commercial banks are shying away from the largest tranche of CLOs in pursuit of better yields elsewhere.

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Citigroup Inc. reports that a staggering 40% of securities issuers have yet to price a new deal this year. This logjam isn't just a concern for financial experts; it threatens the broader economy. A prolonged halt, especially in extending loan bundles, would make it harder for lower-rated businesses to refinance as traditional lenders become more cautious.

The ripple effect continues as lower CLO formation translates to decreased demand for leveraged loans. This, according to Crescent Capital portfolio manager Wayne Hosang, will make it tougher for underwriting banks to place new leveraged buyout papers, and borrowers will face more challenges in refinancing.

With approximately 70% of the US corporate-loan market controlled by CLOs and half a trillion dollars of leveraged loans set to mature in the next three years, the stakes are high. The situation is even more pronounced in Europe.

Unfortunately, there's no cavalry in sight to rescue the situation. While bank appetite is gradually returning, the leveraged loan market remains accessible primarily for "higher-quality issuers." CLOs inherently involve risky lending, adding to the complexity.

The slowdown in CLO market activity is palpable. According to Bloomberg data, US deal issuance and refinancing have plummeted to $102 billion this year, compared to $134 billion last year and roughly $350 billion in 2021, during the peak of the buyout boom.

The senior tranches, considered investment-grade, have seen significant backing from large buyers, accounting for over 60% of the instrument's structure. JPMorgan Chase & Co., Citigroup, Wells Fargo, and Bank of America Corp., which used to acquire the senior AAA component, have either stopped buying or significantly reduced their involvement.

The lack of CLO creation reflects a reduced demand for AAAs, indicating a shift in the market's dynamics. Private finance has stepped in to fill the void, providing comfort to corporate borrowers, but it may not fully replace the exiting CLOs and their US bank sponsors.

In this financial landscape, patience is the watchword for leveraged-finance bankers hoping for a swift return to buoyant buyouts. Barclays Plc CEO C.S. Venkatakrishnan suggests that a dealmaking recovery may be "a little further away," while James Gorman of Morgan Stanley anticipates a resurgence in M&A and capital raising, emphasizing the need for nurturing the green shoots of recovery.

In the end, the CLO market's revival hinges on a concerted effort to address the underlying challenges and restore confidence in this critical segment of the financial ecosystem.