Financial markets have short memories. Of late, they’ve convinced themselves that collateralized loan obligations (CLOs) are much safer instruments than the collateralized debt obligations, or CDOs, on which they’re based and which helped precipitate the 2008 crisis. They’re wrong — and dangerously so.
Current CLOs outstanding globally total around $700 billion, with annual new issues of over $100 billion. That’s broadly comparable to subprime CDO volumes in 2008. Both Bank of England Governor Mark Carney and former Fed Chair Janet Yellen have warned about potential risks; regulators in Japan, where banks have been big CLO buyers, are particularly concerned.
The structure of CLOs is economically similar to CDOs. Each pools multiple loans to create synthetic, bond-like investments. Investors buy a slice (or tranche) of the underlying interest and principal cash flows of the portfolio. A defined order of which investors get repaid first and which bear the most losses allocates risk differentially.
High-risk CLO equity pieces, which are unrated, are first in line for losses and last for repayment. Less-risky subordinated or mezzanine pieces, typically rated anywhere between BBB and B, rank ahead of equity. Low-risk senior pieces, typically rated A or better, rank first for payments and only bear losses if the equity and subordinated pieces are completely wiped out.
CLOs, like CDOs, are designed to increase the leverage on a portfolio of debt. In other ways, CLOs are indeed set up to be safer. Rather than mortgages, subprime or otherwise, they repackage corporate loans, primarily leveraged loans, as well as consumer credit such as automobile loans. Investors in better-rated tranches have greater protection than they would have in CDOs, as higher levels of losses are required before they lose money.
Until recently, they could also rely on the fact that the banks structuring these packages had to retain a minimum amount of the riskiest securities to ensure that they had skin in the game, better aligning their interests with those of investors. The kind of dodgy innovations we saw in 2008 (remember CDO Squared?) haven’t recurred.
Nevertheless, many risks remain. How safe or not CLOs are is contingent on several factors: the credit quality of the underlying loans — as judged by the risk of default and the extent of loss if there is a default — as well as the correlation between default and losses within the portfolio.
Several aspects of this risk aren’t well-understood. The credit quality of the leveraged loans which underlie the bulk of CLOs is poor, typically not investment-grade. Borrowers are highly leveraged. The loans increasingly have minimal investor protection, with over 70 percent lacking any covenants that would allow monitoring of financial condition and early intervention to manage problem borrowers. This exacerbates the risk of higher losses.
Investors assume that the portfolios are safer because they’re diversified. Yet, relative to mortgages, corporate-loan portfolios typically are made up of fewer and larger loans, which increases concentration risk. Leveraged loans are highly sensitive to economic conditions and defaults may be correlated, with many loans experiencing problems simultaneously.
Even buyers of high-quality tranches, who may be insulated from actual losses, face the possibility of mark-to-market writedowns, where the current value of securities declines. Relatively minor losses could impact such investors by reducing the protection for higher tranches and triggering rating downgrades. Similarly, general problems in credit markets, where margins increase, will decrease values.
Where investors are leveraged, falling values will result in margin calls. Hedge funds invested in riskier tranches will face withdrawal of funding and redemptions. Some investors, such as mutual funds, may be forced to sell because of loss or rating triggers.
Japanese banks, which have bought up to 75 percent of AAA CLO tranches and perhaps one-third of all CLOs, finance their holdings by borrowing dollars and euros in the inter-bank markets. Losses may create difficulties in rolling over funding, leading to a liquidity squeeze. As in 2008, that would accelerate declines in prices.
As we saw last December, problems with CLOs may result in a contraction of credit. CLOs purchase 50-60 percent of all leveraged loans, just as CDOs funneled funds into mortgages. The demand from CLOs has underpinned decreases in the price of credit and looser lending terms.
In the case of a downturn, the risk is that CLOs will create adverse feedback loops. Banks will be stuck with unsold inventories of underwritten loans. Falling prices, rising spreads and tightening credit availability will cause credit markets to seize up. Tighter credit will feed into the real economy, setting off losses, selling and price declines. Fears about the financial position of banks and investors will create contagion as depositors refuse to fund banks and investors demand their money back.
There are too many parallels to 2008 for comfort. Investors, many with uncertain expertise and weak holding power, have increased their exposure in the search for higher returns, which can be as high as 20 percent for the riskiest equity pieces. Bankers have aggressively underwritten leveraged loans and structured CLOs, earning around $2.8 billion last year. Built into this speculative episode, like its predecessors, is a euphoric flight from reality and a blindness to risks that continue to rise.