One key difference between the current Covid crisis and the 2008 Lehman crisis, often cited by experts, is the fact that the crisis then emanated from the financial system and then hit the real economy whilst this is just a health crisis hurting the real economy through lockdowns temporarily and in fact that the financial system is quite robust. This is supported by the reforms that ensued the Lehman crisis that forced banks to beef up their balance sheets with higher capital buffers, prohibit them from punting on risky assets and be more transparent in their disclosure of holdings of risky assets. However, this piece in The Atlantic shows why the more things change, the more they remain the same. Collateralised Loan Obligations or CLOs are likely to be this crisis’ villains much like CDOs busted the financial system back in 2008.
“A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.
…the CLO market is bigger than the subprime-mortgage CDO market was in its heyday…[BIS] estimated the overall size of the CDO market in 2007 at $640 billion; it estimated the overall size of the CLO market in 2018 at $750 billion. More than $130 billion worth of CLOs have been created since then, some even in recent months. Just as easy mortgages fueled economic growth in the 2000s, cheap corporate debt has done so in the past decade, and many companies have binged on it.”
Much like back then in 2008, the current Fed Chair and the Treasury Secy have waxed sanguine about CLOs saying banks hold only high grade CLOs and therefore not a cause for concern.
“…AAA rating is deceiving. The credit-rating agencies grade CLOs and their underlying debt separately. You might assume that a CLO must contain AAA debt if its top layer is rated AAA. Far from it. Remember: CLOs are made up of loans to businesses that are already in trouble…. 67 percent of the 1,745 borrowers in its leveraged-loan database had a B rating. .. B-rated borrower’s ability to repay a loan is likely to be impaired in adverse business or economic conditions. In other words, two-thirds of those leveraged loans are likely to lose money in economic conditions like the ones we’re presently experiencing
So while the banks restrict their CLO investments mostly to AAA‑rated layers, what they really own is exposure to tens of billions of dollars of high-risk debt. In those highly rated CLOs, you won’t find a single loan rated AAA, AA, or even A.
How can the credit-rating agencies get away with this? The answer is “default correlation,” a measure of the likelihood of loans defaulting at the same time.
..In theory, CLOs are constructed in such a way as to minimize the chances that all of the loans will be affected by a single event or chain of events. The rating agencies award high ratings to those layers that seem sufficiently diversified across industry and geography.”
So just like in 2008, the myth of the housing market being local and hence unlikely to see corelated defaults across geographies got busted, the nature of the current crisis which is hurting businesses across industries and geographies means that the default correlation excuse for layered CLOs may not pass muster and will likely lead to a mass default of leveraged loans.
The bulls highlight the Powell-put where the Fed has now included CLOs among the securities that it could buy on its balance sheet if need be, as a downside protection to this risk. The author however reckons the rising populism among politicians may not allow a bailout of the financial system this time around. It remains to be seen if the American political system could afford another bust, both politically as well as economically.
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