Financial Crisis Watch: CLOs are the new CDOs

The state of affairs is looking alarmingly like the lead-up to the last financial crisis. Have we already forgotten lessons learned at such great cost the last time around?

We're all still living in the aftermath of the last financial crisis. But human beings have short memories, individually and collectively, and you could be forgiven for thinking that a lot of people - most especially economists and market analysts - have forgotten about that crisis already. A mere decade after the near-meltdown of the global financial system, and most of the financial reforms passed in its wake have already been rolled back.

There are worrisome signs that we are headed for a repeat of 2007-2008. Analysts are pointing out similarities between recent market conditions and those preceding the last crisis. For a good explanation of the role of CDOs in the last crisis, see:

Collateralized Debt Obligations And The Credit Crisis (The Balance)

Note the line in the above piece -

"When the final history of the crisis is written, it's likely that we'll have a better idea of exactly what went wrong. But even now it seems clear that the global debt markets' woes began not so much in the housing market as in the CDO market of 2007."

 This is important to keep in mind. Sure, the housing market did suffer a downturn, but it retrospect it seems that this largely could have been avoided if not for the greed of the mortgage companies and investment banks.

It looks like deja vu all over again, because the collateralized loan market has come roaring back in the last few years. Now it's CLOs (Collateralized Loan Obligations) that are all the rage. Whereas CDOs packaged consumer mortgages into securities, CLOs use corporate debt as the underlying collateral. But the idea is the same - debt is packaged and sold in securities which are structured into tranches which determine risk level, yield, and repayment priority.

I call your attention to a detailed analysis of the current economic and financial environment:

The Ghost Of Failed Banks Returns (SeekingAlpha)

This piece draws historical comparisons with the crisis of 2007-2008 as well as the failure of Austrian bank Creditanstalt in 1931. The author of this piece clearly has some experience in the financial industry - they discuss in some detail the collapse and nationalization of Northern Rock in the UK in 2008, and other events in the run-up to the bursting of the credit bubble, from a knowledgeable insider perspective. There is also discussion of the recent upheaval in the repo market, which is a very important topic that I will be discussing in a separate piece.

There's a lot of analysis and discussion in the above article, so I encourage you to read it in full. The heart of the discussion of CLOs and their role in the financial system is that

Collateralised or not, leveraged loans are bank loans to highly indebted corporations with high interest servicing costs barely covered by earnings, and mostly rated at less than investment grade. In an economic downturn these are the businesses that are the first to fail, and underlying asset quality is already reported by the BIS to be deteriorating. Furthermore, as global interest rates and bond yields have fallen towards and into negative territory, the demand for higher yielding CLOs has increased and the underlying quality decreased. The debt to earnings ratio of leveraged borrowers securitised in CLOs has risen and CLOs without maintenance covenants have grown from 20% in 2012 to 80% in 2018.

In its report, the BIS warns that there are additional spill-overs that could arise from disruptions in market liquidity, a statement that is particularly apt considering the current disruption in the repo market. Given the involvement of hedge funds, fixed income mutual funds and bank loan funds, when the credit cycle has more obviously turned there will almost certainly be a rush to sell these CLOs, likely to lead to fire sales with a potential to cascade losses in the manner seen with residential property CDOs eleven years ago.

In other words, we are on a remarkably similar trajectory to the last crisis. In some ways - negative interest rates, public and corporate debt, political breakdown - we are in even worse shape than a decade ago. Many economists, analysts, and other financial and political leaders are asleep at the wheel, still debating whether there is even a recession coming, attempting to reassure us that there's nothing to see here as the financial system begins to teeter on the brink.

Of course there's a contrary view - to some observers, CLOs are "the heroes we need right now." But this piece, if anything, confirms the view that most financial analysts and product salesman are incredibly short-sighted. There's nothing here to convince me that we're not witness the same large-scale phenomenon as we saw the last time around, though some of the details might be a bit different. That "there is no faster way to annoy a CLO manager than to enquire innocently if their product is 'like a CDO'" isn't a substantive response to questions about the role of CLOs in the markets. CLO managers may not want customers to associate their products with highly-stigmatized CDOs, but that doesn't make the similarities any less real. Stressing that "CLOs, fundamentally, are just a tool to put more leverage on pools of leveraged loans" only highlights the house-of-cards quality that makes the widespread adoption of these products so disturbing. And reminding us that "a market thick with CLOs is a market awash with buyers of last resort" recalls the too-big-to-fail logic that brought us so close to the brink a decade ago, when massive central bank intervention (at taxpayer expense) was required to narrowly avert the disaster brought on by over-reliance on leverage and 'creatively' structured financial products and derivatives. And these are supposed to be arguments in favor of CLOs?

In this view ("the heroes we need right now"), which is more marketing than analysis, the bugs of CLOs in the current market (relatively high yields despite a low and deteriorating quality of underlying assets) is actually a feature! Institutional investors can still get good yields even in a weak market with a dangerously inflated corporate debt bubble! Abracadabra! But there's no free lunch, and this type of financial chicanery only serves to disguise serious underlying problems and allow the bubble to continue inflating. That means it will burst that much more violently when reality does finally set in. Buckle up.


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