Ireland’s growing role as a host to esoteric vehicles for repackaged loans of highly indebted companies internationally could see it caught up in an international financial shock if corporate default rates spike.
US and British private equity firms and asset managers have driven a boom in collateralised loan obligations (CLOs) vehicles in Ireland in recent years. These repackage pools of corporate loans into bonds that are sold to investors.
Total assets in Irish-based CLOs spiralled to €78 billion in first quarter of 2019 from €15.7 billion five years’ earlier.
An estimated two-thirds of the outstanding value of European CLOs is now domiciled in the Republic, the Central Bank said in a paper published on Friday on Ireland's market-based finance, or shadow banking, industry.
CLOs are a small, but fast-growing, part of €4.5 trillion non-bank finance sector in Ireland, which has more than doubled in size in the past decade and ranks as the sixth largest in the world. Regulators internationally are becoming increasingly concerned about CLOs, which share some features with subprime collateralised debt obligations (CDOs) that played a major role in the 2008 global financial crisis.
The global leveraged loans market is estimated to be between $1.4 trillion (€1.25 trillion) and $2.2 trillion in size.
Only a tiny portion of non-bank finance assets in Ireland relate to the domestic economy. Two-thirds relate to international investment funds and money market funds, which are heavily regulated.
While the prospect of an entity in the International Financial Services Centre (IFSC) imploding would cause more reputational damage than a direct cost for Irish taxpayers, the new Central Bank governor Gabriel Makhlouf has set a priority on assessing the risks in the sector, including parts, such as CLOs, that are not regulated.
The Central Bank paper, written by Simone Cima, Neill Killeen and Vasileios Madouros, noted that the protective covenants tied to leveraged loans in CLOs have become weaker – or, in financial jargon, cov-lite – in recent times.
“Consistent with global trends, the proportion of leveraged loans held by Irish-domiciled CLOs with cov-lite contracts increased steadily in recent years to reach 84 per cent of the loans in the books of Irish CLOs as of the second quarter of 2019,” it said.
“Leveraged loans allow highly indebted corporations to obtain new funding, and the activity of CLOs contributes to increased demand for leveraged loans through a more diversified investor base,” said the Central Bank paper.
“Therefore, CLOs can both facilitate financing to the real economy and spreading risks among different types of investors. However, in the underlying market for leveraged loans, there is also some evidence of increased risk-taking, lower credit quality and weaker covenants, which can pose vulnerabilities.”
Euro zone investors are the main holders of CLO securities, followed by those in the US, Japan and the UK, the paper said. More than half of the euro zone investors were investment funds, followed by insurers and banks.
