Growing risks from CLOs — is history doomed to repeat itself?
Last Friday, the S&P 500 closed the day up 0.66%, breaking the key 2,900 level for the first time in six months. That put it less than 1% from a record high.
Everything’s great, right? Perhaps, for the moment.
But while stocks are surging, there’s a very real danger brewing in the credit markets. We discussed this on our , noting how corporate debt has increased 86% since 2007. The concern is that many corporations locked in low rates a decade ago. But $3.5 trillion of debt from high-yield and investment-grade issuers will be coming due in the next three years. That means many of these companies will have to roll over their debts when interest rates are much higher.
It turns out there’s another specific concern here — one that has hints of 2008.
It’s been on Neil George’s radar since last October, and the financial media is beginning to pick up on it as well. So, in this Digest, let’s make sure you’re aware of what’s happening. That way, we can toast the surgingstock market today while preparing for the risks of tomorrow.
***The danger involves something called “collateralized loan obligations” (CLOs)
I’m going to turn to Neil, editor of , to help explain a CLO. Neil is a master income investor, helping subscribers find high-quality income, whether that be from dividend stocks, bonds, REITs, MLPs, or other instruments.
From Neil’s January issue of :
(A CLO) is where companies obtain loans from individual or syndicated groups of banks, which are then either held or pooled and in turn sold into the market, where banks and other financial firms invest in them.
CLOs are a great means for banks to reduce credit risks in their loan portfolio while also providing investors with higher yields and companies with additional funding opportunities.
The downside is that the loans tend to be light in documentation as opposed to traditional origination of corporate bonds. The originators, eager for fee income, can push transactions that might lean on the aggressive side. And buyers of CLOs often don’t or can’t do their homework on what’s really under the hood. And since many of the underlining loans in CLOs are subordinated to corporate bonds, there is additional credit risk if and when something goes wrong.
Now, if all of that sounds somewhat familiar, it’s because CLOs are very similar in nature to CDOs — which are “collateralized debt obligations.” And we all fondly remember CDOs as the financial weapon of mass destruction that nearly destroyed the global economy back in 2008.
Now, CLOs aren’t inherently bad. The problem — similar to what happened with CDOs — is when investors don’t “do their homework” as Neil said, separating quality CLOs from the trash.
Back to Neil:
As long as the originators are good at credit analysis and the investors take the time to know them before they buy, it’s all good.
However, as we found out in 2007-2008, many buyers don’t do their homework. And when cracks formed in the underlying loans, black holes began to form on the balance sheets of banks and financial firms.
The surge in CLOs last year tells me that the threat is very much upon us again.
***Neil’s concern about CLOs is now being picked up by the financial media
The “surge” Neil mentioned was echoed in a report last Friday from :
The size of the CLO market has doubled in the last decade. The whole process effectively mirrors how bad mortgages spread throughout the financial system in the run up to the 2008 crash.
Now the boom is potentially set up for a similar bust: If large amounts of this debt does go bad, it will likely happen in 2021 or 2022 (or perhaps later in 2025), when large batches of the loans come due.
Other financial media outlets are picking up on the risk as well. Note the title and slug line from :
From that article:
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.
***Part of the problem is we’re not doing enough to prevent tomorrow’s meltdown today
A recent , built off conversations with 31 current and former officials and bankers, detailed some safeguard concerns. Specifically, Trump’s appointees have removed or ignored some of the regulatory policies that limit corporate borrowing.
So, what’s the impact of that?
By the end of last year, roughly $1.15 trillion in leveraged loans were outstanding — that’s more than twice the volume that existed just prior to the 2008 crash.
A February report from Bloomberg added more color to this, revealing that almost 80% of leveraged loans now lack basic safeguards, such as requiring borrowers to avoid additional risky borrowing.
***What’s the real risk here? How might this play out?
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.
Shades of the Great Depression’s bank-runs, would you say?
***So, are we doomed to have history repeat itself?
It certainly appears there are similarities. Bloomberg notes the echoes of 2008:
The boom (in CLOs) bears striking similarities to the mortgage frenzy that preceded it … Investor demand for these securities is so strong that it has pushed lenders to lower standards. They’ve largely stopped including loan covenants that, for example, require borrowers to avoid taking on too much debt or generate ample cash for interest payments …
The result is a financial vulnerability that could sharply accelerate any economic downturn. If a spike in defaults caused investors to flee and lenders to pull back, otherwise healthy companies could find themselves unable to refinance their debts, forcing them to lay off workers or even go bust. If the resulting losses crystallize in institutions central to the financial system, the repercussions could be still greater.
***So, what can we do about this?
Well, first, this is a systemic issue that’s far beyond our ability to directly control. If worst-case scenarios are going to play out, you and I will be affected.
That said, our best defense is a balanced asset allocation. That means not having all of your wealth concentrated in only stocks or bonds. There’s also gold, real estate, various commodities, even cash.
And, of course, though it might be common sense, take the time to know what you’re investing in.
On that note, I’ll give Neil the final word:
The trouble back in 2007-2008 is that the investors didn’t take the time, nor the effort to fully analyze and comprehend the underlying values of the pooled assets and liabilities.
Rinse and repeat is unfortunately the reality of the financial markets. And if we’re not careful, we could eventually see another event like the Great Recession.
Have a good evening,
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.