Goldman Lowers EPS Growth Est For Q3 To -30% From -21%, No Longer Sees Full Q4 Recovery

In a replay of 2008, toxic subprime loans could worsen this financial crisis

In April, Moody’s placed 20% of its rated collateralized loan obligations (CLO) (valued at around $22 billion) on review. The decision carried ominous echoes of 2008 and the Great Financial Crisis, when collateralized debt obligations (CDOs) proved problematic for the U.S. and global economies. In the current financial crisis, CLOs, which — despite industry protestations to the contrary — share many of same structural characteristics as CDOs, may cause similar problems.

Like mortgage securitizations, CLOs package portfolios of corporate loans (often of lower-quality) into investable securities. Investors do not take a pro-rata interest in the portfolio but instead take different slices of risks. In return for higher returns, investors in the equity or subordinated tranches take the first losses. Meanwhile, Investors in the senior tranches are protected against these first losses and receive lower returns. In recent years, the underlying assets used have been riskier non-investment grade leveraged loans.

The equity tranche investors are typically hedge funds, private equity, institutional investors (pension funds, insurance companies), some mutual funds (depending on their mandates) and high-net-worth individuals. Some emerging-market banks also purchase the equity tranche. Generally, they are looking for the high yield and hoping for either no defaults or just a few.

To enhance investor returns, CLOs have introduced higher levels of leverage and complex risk. While banks are required to hold capital of up to 16% against their loan exposure, CLOs, which are not regulated, hold significantly less. This increases leverage, generating potentially higher returns for shareholders.