Arjun Goyal Business

CLOs: Can this story have a happy ending?

A new security, Collateralized Loan Obligations, seem eerily similar to the securities that brought down the financial system in 2008. What is it really about?

By: Arjun Goyal

A new security, Collateralized Loan Obligations, seem eerily similar to the securities that brought down the financial system in 2008. What is it really about?

If the 2008 financial crisis was a movie, we would have the Federal Reserve as the hero, Fannie Mae and Freddie Mac as our villains, and the housing market as our producers. The weapon being used by our villains would be the ominous sounding ‘mortgage backed securities’. To summarize the plot, when the housing market fell in 2007, mortgage backed securities lost most of their value in a matter of weeks, dragging down the banks and financial institutions that held them in large quantities. After large scale capital injections, bailouts and implementation of safeguards for the future (the Dodd-Frank Act), the culmination of the crisis was finally upon us after several grueling months.

The technical name for Mortgage Backed Securities is a Collateralized Debt Obligation, or CDO. Apart from sounding like something that would put you to sleep, it is essentially a security (obligation) that derives its value from debt that has some collateral behind it in case there is a default (just like a mortgage has a house as its collateral). Because of their role in the financial crisis, CDOs and MBS are villains in wider society, and one would imagine that investors would not be putting their money in this. But there is a similar security that has currently hit the market that is eerily similar to CDOs, known as Collateralized Loan Obligations. I think it’s important that we all understand what these securities are, and what its implications could be.

New Kid on the Block: What are CLOs really?

The best way to describe CLOs would be to use the analogy of a pie. Imagine that your favorite patissiere represents the financial institution making the CLO; let’s use Blackrock as an example. The patissier needs to make a lemon pie (our CLO). He begins to make the filling for the pie by combining cream, sugar, egg and lemon extract. In the financial market, these ingredients represent claims to different types of loans. These are largely corporate loans made to firms looking for debt to finance their business. However, just like there are many types of ingredients, there are also many different types of loans. Most CLOs have a combination of low-risk and high-risk loans, with risk being determined by what kind of companies these loans have been made out to. A loan to a stable company with a positive future outlook (as determined by a ratings agency) would be deemed as low-risk, and those made to sketchier, lower credit rated firms are deemed as high risk loans. What one has to note, though, is that high risk loans entail a higher cash flow return for the holder of the obligation, since the interest rates for these loans are risk adjusted (high risk, high reward). Most CLOs also have a portion of the equity of these companies in them, which is the riskiest portion of it since equity-holders are paid last by debtors. However, it is also the most lucrative portion, often yielding returns between 10-20%!

Next steps: Our patissier takes this mixture and whisks it together, pours it in a tart base and bakes it in an oven at 175 degrees Celcius for 20-30 minutes (that’s 350 degrees F for the American Masterchefs out there). And voila, we have ourselves a succulent tart that we can slice up and sell to the public. Blackrock does the same thing: it takes these loans (and equity), combines them together to make them into a single security, or a CLO, and divides them up into tranches that it sells to investors. However, there is a catch.

Sugar in a pie is what makes it great, but too much sugar in it can curdle the mixture and ruin our dessert. High risk loans are just like the sugar, since the high returns make the CLOs have above-average returns, but going overboard on risk means that the security becomes extremely unstable, and defaults on the underlying loans can make the whole thing go under.

To most investors, and myself as well, CLOs sound eerily similar to CDOs and mortgage backed securities. This is the way experts in the industry would put it: CLOs can be seen as a subset of CDOs, where CLOs only contain bank loans made to corporations. What makes CLOs especially popular is the ability for the bank issuers to customize them based on investor demand. Another interesting fact to note is that CLOs also contain leveraged loans from leveraged buyout merger projects, which are often considered quite risky.

Selling like hot cakes

Considering the effect that CDOs and mortgage-backed securities had on the 2008 financial crisis, investors should be running away from CLOs. The reality is quite to the contrary. CLOs have been one of the most popular specialized structured debt instruments in the market, and this is in spite of the fact that a large portion of CLOs is becoming riskier. For example, one of companies whose loans were part of CLOs was Sears. Yes, the same Sears that just filed for Chapter 11 bankruptcy protection.

Still, investor appetite for risk remains unsatiated. James Mackintosh wrote in the Wall Street Journal that “while weaker credit standards mean bigger losses when loans turn sour, they will help magnify market gains as long as the economy stays sweet”. He’s right, and in the current market where deregulation and pro-growth policies have been the norm, investors only see an upside to these instruments. Just last year, leveraged loans hit a value of over $1.5 trillion. Asset managers like Allianz Global and Apollo Global Management have more than 85% of their loans being managed as CLOs (Allianz is at 97%). Cash rich firms like insurance companies, and organizations like Bill and Melinda Gates Foundation and the family offices of Paul Allen have CLOs as fixed income instruments in their portfolios. It’s a crowd favorite.

Does this plot end in tragedy?

The lack of significant difference between CLOs and CDOs causes significant concern regarding the future of the financial system. And in my opinion, it should. I don’t want to use the word bubble to describe this market, though many do claim that we are in the exposition of one, but the unbridled optimism with which investors have been eating up risky debt is extremely concerning. The high liquidity for these instruments is leading to slipping credit standards, and the covenants that are usually put in place to prevent defaults are starting to loosen. Interest rates are also expected to rise, with the Fed having already hiked them three times this year. Since these loans are mainly floating rate loans, investors are expected to continue flocking to this market in bunches. This is worsened by the fact that the Dodd-Frank Act has been under fire with large scale financial deregulation occurring, especially with regards to policies safeguarding CLOs from taking on too much risk.

But many say that the situation in the market is not like what it was when housing bubble was at its peak. The New York Times notes that the CLO market is only about one-tenths the size of the housing market in the years leading up to the 2008 crisis. Additionally, the top level, low risk tranche of CLOs have never defaulted, even in the thick of the financial crisis. Some also say that if the CLO portfolios are diversified in their loans, there is a possibility to minimize risk while maximizing reward.

Nobody definitively knows the effect these securities could have when the downturn is upon us. Yes, we are currently booming and CLOs are flourishing, but the boat might sink when the business cycle takes over and the economy starts to cool again.

I’d like to think that as creatures with strong memory and reasoning skills, we would have learned our lessons. At the same time, I’m not surprised that the allure of profits overcomes this twice-fold. Personally, I’m not too optimistic on the future of CLOs and their effects. I would want nothing more to be proven wrong. The last thing we need is a sequel to The Big Short (I highly recommend watching it to get a better understanding of this market), where a Christian Bale-esque investor reaps profits as the whole world burns down, again. The jury is still out on this story’s ending; time will tell if it ends in tragedy.

Works Cited

LLC.cls-1, J. Z. (2018, March 28). Are CLOs The Next CDOs? Retrieved from https://seekingalpha.com/article/4159460-clos-next-cdos

Phillips, M. (2018, October 19). Wall Street Loves These Risky Loans. The Rest of Us Should Be Wary. Retrieved from https://www.nytimes.com/2018/10/19/business/economy/clo-corporate-loans.html

Fitch Ratings. CLO Asset Manager Handbook. Retrieved from https://www.fitchratings.com/site/dam/investors/US-CLO-Asset-Manager-Handbook.pdf

Kurt, D. (2018, March 30). Collateralized Loan Obligation – CLO. Retrieved from https://www.investopedia.com/terms/c/clo.asp

Bloomberg News. Popularity of collateralized loan obligations widens thanks to demand from rich. Retrieved from https://www.investmentnews.com/article/20180905/FREE/180909976/popularity-of-collateralized-loan-obligations-widens-thanks-to

Bloomberg News. Popularity of collateralized loan obligations widens thanks to demand from rich. Retrieved from https://www.investmentnews.com/article/20180905/FREE/180909976/popularity-of-collateralized-loan-obligations-widens-thanks-to 

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