In a new report, Fitch warns investors about CLOs:

“…given the evolution of leveraged loans from a relatively illiquid asset class at the inception of the CLO market to a more actively traded credit product, Fitch questions the practice of accounting for loans at par regardless of the discounted purchase price threshold. There are elements of the current loan market that are not directly addressed through Fitch’s rating criteria, but should not be ignored.”

Remember the recent rush by banks to buy discounted assets on the open market? Although this report was not specifically focused on how banks treat these assets on their balances sheets, if the CLO manager is a bank, it appears possible for the bank to buy-on-the-cheap loans and account for those loans at par rather than the price actually paid.  Note that this activity would not be adjusting values due to the recent relaxation of mark to market by the FASB.  This shenanigan is separate.

Fitch explains:

Discounted security purchases are generally permitted, but holdings beyond 5% of the portfolio notional balance are generally carried at their purchase price for purposes of overcollateralization (OC) tests.

This structural feature reduces the OC credit given to discounted securities and is intended to protect investors from the following:
• Egregious Par Building: Creating credit enhancement by measuring assets purchased at considerable discount to par at par value rather than their purchase price.

• Adverse Selection: Accumulating assets with relatively weaker credit profiles as indicated by lower than average market prices.
While the intention of the discounted security adjustment has merits, Fitch has long identified issues with its practical application.

In today’s environment, in contrast to the par loan market several years ago, almost all loans are trading below 85% of par. As such, most of the leveraged loan universe would be considered as discounted securities. Since managers account for discounted securities at their purchase price rather than par, there is a disincentive for a CLO manager to make substitution trades, which may be needed to improve the credit quality of the underlying pool of loans.