‘Warehoused’ Loans Can Create Wins for Banks, Losses for Investors
A new study from Securities Litigation and Consulting Group (SLCG) investigates the subject of “warehousing” loans and the conflicts of interest that can result when investment banks accumulate loans for potential securitization prior to the issuance of a collateralized loan obligation (CLO).
Findings from the study, titled Collateralized Loan Obligations, Warehousing, and Banc of America’s Undisclosed Losses, conclude that banks may use warehousing as part of a “trade allocation scheme,” and that the practice could eventually lead to some CLO trusts issuing securities without disclosing to investors the fact that the securities had lost almost all their value because the CLO trust was committed to paying substantially more than the market value of the warehoused loans.
A CLO is a collection of loans made by banks to corporations with significant amounts of leverage. The loans themselves are grouped together into a securitization pool that is then divided into several tranches. Interests in the tranches are sold to investors.
Two CLO offerings by Banc of America are provided as examples in the study: LCM VII and Bryn Mawr II. According to the study, $35 million in losses that had occurred prior to the issue date of CLOs were shifted from Banc of America to investors without disclosure. Ultimately, investors lost approximately $150 million in the two CLOs when they failed market value triggers in October 2008 and were liquidated.
“Banc of America’s problematic July 2007 CLOs highlight the potential for opportunistic trade allocation created by warehousing arrangements. If CLO trusts “ramp up” their portfolios, using proceeds from issuing securities to purchase loans at contemporaneous market prices, CLO investors incur only losses occurring after they buy the CLOs’ securities,” the study says.
SLCG shows Banc of America buying or financing leveraged loans between November 2006 and June 2007 at slightly above par and then sold the offerings to investors in the LCM VII and Bryn Mawr II trusts in late July and early August despite the fact that the loans had lost 5% of their value in July 2007. The losses occurred before the two CLOs closed – information that was never disclosed to investors in either marketing materials or private-placement memorandums.
It wasn’t until later, in August 2007, that Banc of America – starting with Symphony IV – began partially telling investors about embedded losses in newly issued trusts’ portfolios.
The authors of the study say the problem of warehousing and the resulting conflicts of interest go beyond the Banc of America example. Citigroup also issued a similar CLO, Bridgeport II, at the end of July 2007 without telling investors about losses that had already occurred in the loan portfolio.
Moreover, the issue isn’t isolated to CLOs. Collateralized debt obligations (CDOs) backed by warehoused CDO tranches and which had declined in value in early 2007 also appear to have been securitized with embedded and undisclosed losses, the study says.