Open ended loan funds: an illiquid lunch
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Open ended loan funds: an illiquid lunch

empty bottles

Insurance companies taking leveraged loan exposure through open ended funds, rather than CLOs, should cause alarm. Given the liquidity risk inherent in the structures, regulators ought to be watchful.

Plenty of investors have come back to the CLO market this year, but one group remains notably absent — the small and mid-tier insurance companies that once formed the bedrock of the CLO and securitization market.

Stifled by the Solvency II regulation, smaller insurance companies find it uneconomical, using the standardised model, to invest in structured credit. The capital weightings are disproportionately high compared with the underlying asset.

Those companies who want exposure to leveraged loans have increasingly been turning to open ended loan funds, instead of the CLO market. A similar trend has been seen in the Dutch mortgage market, with insurance companies preferring to buy bulky portfolios of whole loans, instead of more heavily penalised RMBS deals, backed by the same loans.

Insurance companies are vastly underestimating the liquidity risks of these investments.

There is no ready market for the trading of whole loans. And you only have to look at the numerous open ended UK commercial property funds that were gated after the country's EU membership referendum to demonstrate that daily liquidity can swiftly vanish in times of stress.

CLO liquidity might not be perfect — but a secondary market does at least exist.

The desertion of small insurance companies demonstrates once again that European financial regulation remains skew whiff, forcing buyers into other, less suitable investments that could lead to a build up of risk elsewhere in the financial system. The securitization market’s fight for better regulatory treatment might be sounding repetitive, but it is worthwhile.

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