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SVB and the case of the missing CLO exposure

By Sayed Kadiri

Friday, March 17, 2023

Silicon Valley Bank’s collapse has dealt credit markets another hammer-blow with the past 12-months bearing witness to more dips than a mezze platter. Whereas past misfortunes in credit have provided an opening for some observers to critique the ‘toxic’ structure that is a CLO, this time things are a little different.

A scan of SVB’s roughly $117 billion investment portfolio shows that an alarming 92% was held in US treasuries and government-sponsored MBS. The remainder was formed of yet more fixed-rate in the form of municipal and corporate bonds.

The bank held $212 billion of assets as of the end of December with the fixed income portfolio (chock full of fixed-rate exposure in a world of rapidly rising interest rates) making up 55% of that. Net loans extended to clients made up 35% (mercifully, 92% of that was floating rate) of the asset pool with cash about 7%.

It’s easy being a Monday morning quarterback, but the question has to be asked: why was there no space allocated to CLOs? It would not have staved off a bank run, but it would have put SVB in a better position to withstand the stampede.

Affinity for treasuries

US regional banks are natural buyers of treasuries and other agency MBS (where there is an implicit guarantee) because these bonds are immune to credit risk. But problems can arise when marrying long duration assets to deposits that are shorter duration, susceptible to large outflows, or reprice more frequently with rate increases (frequently referred to as having a higher deposit beta).

According to one banker, it’s a compromise that many bank treasurers and CFOs are willing to accept. “Treasuries and agency MBS are staples of depository portfolios, rightfully so, given their liquid nature, no credit risk, and their attractive capital risk weightings,” he says. “However, the interest rate risk associated with these securities is tangible, and many depositories discount this risk given how long it has been since balance sheets were actually impacted by it.”

Francis Mitchell, a director with Truist Securities, advises banks on balance sheet optimisation and helps depositories adopt portfolio management strategies that include structured products. He says the main components to consider when running the balance sheet are liquidity, interest rate risk and credit risk, but that many banks have a fixation on eliminating credit risk that could reside in investment portfolio.

“Not all depositories fully appreciate interest rate risk, which has led to some taking on sub-optimal risk adjusted returns associated with it,” he says. “I’ve always been a big proponent of embracing credit, especially short credit products that have low risk weightings.  Many people are surprised though when I explain my support for these products is predominately due to prudent risk management, while any yield pickup is a secondary benefit to the balance sheet. Over the past few years, you’ve had spread widening in some of these credit products but unrealised losses are minimal due to their short duration nature. When you compare that performance to the performance of long duration non-credit sensitive products, like agency MBS and treasuries, it is truly eye opening.”

Mitchell points out that SVB had an unrealised loss around 17% on the hold-to-maturity pocket of its balance sheet, predominately tied to higher interest rates.      

The reluctance from regional banks to widen their horizons has been evident when interest rates plummeted in the early 2010s and then remained near historical lows for much of that decade and swung lower again in 2021. For example, looking back at 2018 through 2021, the yield on 4- and 5-year duration agency-RMBS dropped substantially. In order to achieve the same yield, investors would have had to extend duration to six or more years, materially increasing interest rate risk in their portfolio.

For many depositories, instead of countering the poor yield-duration trade-off in treasury and agency RMBS-type products by adding short credit risk, the playbook was to extend more and more with their duration, exacerbating overall interest rate risk. 

“This was SVB’s big mistake,” says Dick Bove, senior research analyst at Odeon Capital in New York.

“The money coming in from deposits was hot and could leave at any time so they bought treasuries on the basis that this is a liquid asset that could meet any request to close accounts. But these securities did not hold up in price.”

The demand for cash and the drop in the value of treasuries was a disastrous mix. Bove says that the episode highlights just how liquid cash is these days.

“This would never have happened if money was a mineral,” he says. “If depositors had to get into their cars, drive down to their banks and ask bank clerks to withdraw their money there would have been operation delays. But in recent years there has been a change in the structure of money – it is an electronic asset. You can simply pull out your phone and move your money in seconds.”  

Ideally, SVB should have heavily allocated to 30-day treasuries, says Bove.

If it felt compelled to pursue longer duration bonds then a robust hedge was needed.

Credit? That sounds too risky to me

There has been a lot of education on the merits of CLOs, and credit for that matter, as part of a diversified investment portfolio. Some regional banks have grown to love CLOs, but for many potential bank investors, the asset’s structure, collateral, and stress testing can be too much to understand and get comfortable with. 

According to Mitchell, ordinarily, a portfolio manager at a regional bank would have to work alongside a chief credit officer or chief risk officer to create underwriting standards, and ultimately purchase approval for asset classes like ABS and CLOs. He says many depositories still consider CLOs as non-traditional depository investments even though they’ve been embraced by many top performing depositories over the past 10-plus years.  In his experience, the credit risk associated with CLOs tends to ultimately fall under the CRO.  

 

“In contrast to credit risk, interest rate risk at a bank tends to fall under the CFO, not the CRO,” says Mitchell. “Traditionally, when depositories get credit products approved, the CRO has a seat at the table, which makes sense. However, in my experience, CROs are very reluctant to take on these additional risks and don’t always understand that these products actually de-risk the bank’s balance sheet due to lower interest rate risk but also their attractive capital risk weightings, and diversification.  Many times, there is a bit of NIMBY [not in my back yard] with the CRO not wanting to take on investment portfolio credit risk, and there lacks incentive for the CRO to do so.” he says.

Past experiences – no matter how long ago – have also scarred treasurers and bank portfolio managers. Some that took on credit risk prior to the 2008 financial crisis and got burned have been reluctant to give credit another chance.

Mitchell, who has managed structured credit portfolios for the likes of TD Bank and Webster Bank, says there is no course to go on to understand CLOs: “I believe for something like CLOs, you have to learn it on the job like I did in 2011. You talk to traders and research groups, network with other PMs, and you have to do the dirty work.  You just dive in and read offering memorandums, understand the structures, and not be afraid of asking questions.”  He went on to say that for a lot of depositories this is too big a hurdle to clear.

The case for short-duration credit

For any bank expanding into credit, Mitchell says short-duration credit positions are ideal for most bank investment portfolios, depending on their overall balance sheet. He believes right now is still a good time to be looking at short credit, but banks will face potential hurdles around optics, and focus more on duration and liquidity. 

He illustrates interest rate risk versus credit risk is by comparing the additional years of duration and price volatility an investor would need to take on in agency MBS versus ABS or CLOs. At a conference in September, he compared double A rated ABS to Agency MBS and explained that investors would have to take on over five more years of duration and an additional 12% of price volatility in a plus-300bp rate scenario. 

Mitchell says it’s not just all about interest rate risk, however.

“When rates rise, MBS positions will get hurt not just by rates, but also by slowing prepayments. Cashflows substantially slow due to lack of refinancings or borrowers moving,” says Mitchell. “But credit products like ABS and CLOs, generally speaking, continue to have decent cash flows for the most part. This is another reason, these products are so important to a balance sheet. I don’t know a bank that doesn’t want more cash flow right now to deal with liquidity issues, potential deposit outflows, or funding loan growth.”

Bove says the way banking regulations are set up, capital requirements for CLO investments are sufficiently high to put off regional banks. Specifically, talc regulations encourage investments in high quality assets and treasuries fall into this bracket, with agency-MBS just a notch below.

“CLOs are private assets, they are not liquid, the market outstanding is smaller, and they just are not right for a traditional bank’s funding profile,” says the first banker.

However, recent evidence suggests that senior CLO paper is well suited to withstand stress. During the liability-driven investment crisis in Europe at the end of last year, pension funds were selling senior CLO tranches in huge volumes as these were among the few assets that held help up well enough in terms of their price.

In years gone by the CLO market has attracted a fair amount of scorn (the uninitiated would draw inaccurate parallels with CDOs of ABS). But this time there might be serious thought given to how CLOs can perform a valuable role in a diversified portfolio.

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TAGS: CLO North America