Norinchukin’s role in the CLO market has rightly been attracting attention. GlobalCapital pointed out that a market reliant on a single investor is hardly the healthiest. There followed stories in theFinancial Timesand the Wall Street Journal about how big the farmers’ bank had grown in US and European leveraged credit.
The regulator is now apparently questioning Norinchukin, as well as Japan Post Bank and Mitsubishi UFJ Financial Group, about their exposure to the global CLO market.
Asking a few questions is prudent. Ideally, regulators would know when their charges are amassing $60bn+ securities holdings without having to read it in the press, but perhaps we don’t live in that world. Maybe Japan’s FSA was subject to direction from even further up the food chain.
There is also a somewhat thoughtful critique of the exposure of Norinchukin to CLO senior securities. While the bonds themselves are pretty bombproof, and a world away from the CDOs of 2007, the cross-currency dynamics at play are uncomfortably similar.
If an institution with a lot of yen deposits, but nothing much in dollars and euros buys securities in those currencies, there exists a currency mismatch. Some Japanese CLO buyers like their senior notes repacked into yen form, or fully hedged. But for others, the positions can either be hedged short term or funded directly by dollar or euro borrowing. If it becomes harder to roll currency forwards, or if money markets tighten, making it harder to source short term liquidity outside one’s home currency, that could spark forced selling, a spiral of price declines, mark-to-market losses, more forced selling, and all manner of trouble.
That works as a partial description of the beginning of the crisis in 2007. European banks were indeed especially short of dollars. A freezing in money markets did spark forced selling. And the crisis was arrested, in part, by the US Federal Reserve’s willingness to provide dollar liquidity in huge quantities to European banks, both through its own lending facilities and through swap lines with the ECB.
So it’s easy to see why regulators might be concerned.
But, there really are large, important differences between the pre-crisis market and CLOs today.
CLO senior notes — indeed, all the investment grade debt from CLOs — came through the global finance crisis unscathed. Structures worked as advertised. Deals from 2006 and 2007 thrived, as they were still within their reinvestment periods, and could scoop up quality loans at bargain basement prices, secure in their sticky term leverage.
The loans they contain are widely understood, widely traded in their own right, and pored over by plenty of credit analysts . Nobody making markets in CLO senior bonds is likely to be blindsided by a sense that their position is suddenly worthless.
Money markets, too, are far less fragile. Collateral is king, and there isn’t enough of it — but that’s because interbank markets have become predominantly secured. If banks are borrowing short term dollars, they’re doing so using their existing collateral.
Any worries about these positions ought to be balanced also by considering the business rationale for the CLO investments in the first place. Japan is a net exporter of capital for good reasons. Its banks really do lack sufficient profitable investments at home, and need to seek out opportunities elsewhere.
And what better exposures than to CLO senior? A book of bank loans, managed by an experienced fund manager with skin in the game, diversified across perhaps 300 different companies, and the exposure taken at senior level. It’s a plug and play diversified exposure to corporate credit across a whole foreign market.
Still, a note of caution is appropriate. Bank regulations include rules about which assets to mark-to-market, which to mark-to-model, and which to think of at fair value. But they have little to say about situations where one institution effectively is the market.
Though the deals printed so far that did not end up at Norinchukin show the Japanese bank only accounts for a few basis points of tighter spread in European senior, its existing holdings are so large as to be effectively unsaleable.
The “market” prints imply Norinchukin ought to mark its 108bp seniors a touch under par, but in practice, the merest whisper that the firm was unwinding its CLO book would send traders running for the hills. Even if every trader and investor knows the bonds are money good, absolutely nobody will stand in front of a speeding train that is $62bn and offered only.
So it’s a delicate balancing act for Japan’s FSA. Cautious encouragement of the banks that have supported profitability, and diversified their asset base through buying CLOs, must be matched by a rigorous look at how the positions are funded — and a frank acknowledgement that they cannot be unwound. Let’s hope they tread carefully.