The Similarities Between the CLO and MBS Markets
CLOs are the new MBS, and in Part 2 of this article, I am going to tell you why (read Part I here). The reason mortgages were sold off to investment banks in the early 2000s was due to the low yield of T-bills and the knowledge of investment bankers that they could securitize and repackage crappy mortgages into a product they could falsely repackage as a “low-risk, high-yield” product, and then easily sell into the market into the never-ending supply of investors that constantly seek higher yield. By now, anyone in the financial industry in any capacity – analyst, banker, salesman, price prognosticator – should immediately translate the “low-risk, high-yield” term into its true meaning of “undisclosed risk, high-yield” at best and “high-risk, high-yield” at worst. There is no truth in the term “low-risk, high-yield” when used by a banker.
When I was still running an investment consulting company, I recall meeting with a client that told me he loved Icelandic bonds, because his London money manager described them as “low-risk, high-yield” financial products that would provide a steady double-digit yield, high-income stream for him in retirement. I recall asking him the amount of the highest yields he was receiving from these “low-risk, high-yield” bonds, and if memory serves me correct, I believe his response was 13% annually. To this, I scoffed and replied that he was delusional if he believed he could receive a 13% yield without taking on massive risk. And to my reply, my client angrily stated that his London money manager had been in the business a lot longer than myself, and if he stated the investment was “low risk”, then he was certain it was “low risk”, even though he could not explain in any coherent manner how the 13% yield was being achieved (which I was certain was being achieved with high-risk strategies).
In any event, shortly after this argument, we parted ways, I wished him luck, and issued a final warning to him that his “low-risk, high-yield” investments could go to zero. And sure enough, in less than a year from our time of discussion, the three biggest banks in Iceland, Glitner Bank, Landsbanki Bank, and Kaupthing Bank, all began to rapidly collapse as his near “zero risk” investments headed to zero. As I had ended my professional relationship with him, I don’t know if he exited before his “low-risk, high-yield” investments crashed to zero, but given his stubbornness to listen to a dissenting view (a topic I’ve discussed many times in the past), I imagine that if he exited before his investment crashed to zero, that it was after a massive loss.
And the above narrative upon which my client was sold to dump a massive portion of his retirement funds into Icelandic bonds was the exact same narrative that surrounded MBS products during the early 2000s. Investment bankers basically blackmailed the largest ratings agencies in the US to grant their products wildly undeserved AAA credit ratings, not only threatening to take their business to agency rating competitors if their MBS products did not receive the AAA ratings they demanded regardless if they deserved them or not. Believe it or not, this is how the discussions between investment bankers and Credit Rating Agency employees often when down in the fraudulent process of securing undeserving AAA credit ratings.
Massive Degradation of CLO Collateral
Investment bankers argued to the major US credit rating agencies of Fitch, Moodys and Standard and Poors that they could package mortgages rated just two tranches above “junk”, BBB-rated, from different issuers, and that simply by packaging BBB-rated mortgages issued by different banks, that this “diversification” diversified away risk into nothingness so their MBS product deserved a AAA-rating. In term, the US credit rating agencies agreed that this absurd explanation of non-existent diversification greatly decreased risk and granted investment bankers their highly sought-after AAA rating, a rating that was literally eight to ten tranches higher in rating than the one it deserved (junk begins at BB+ and lower). In order of worse to better, credit ratings proceed from BBB-, BBB, BBB+, A-, A, A+, AA-, AA, AA+ and then AAA).
This illustrates how criminally the ratings agencies employees acted and that none among them that rated MBS products in the early to mid-2000s had any integrity and any desire to inform the buyer that they were buying garbage rated with the highest credit rating possible. An analogy to the criminal behavior of the ratings agencies back then would be to literally take shit defecated by a variety of animals like dogs, cats, elephants, tigers, wolves, and lions, and then claim that by packaging the different types of defecation together, that this diversification could kill the stink of the pile of shit and make it smell like roses. This is how absurd was the argument of investment bankers and their credit agency rating employees in collaborating to ensure that the junk contained within many MBS products were rated AAA.
So forgive me if I don’t believe the same banking narratives being pushed about how CLOs, products designed to produce “low-risk, high-yield” returns are “far better alternatives” than MBS derivatives in the mid-2000s to the non-existent yields of T-bills today (that in February 2022 ranged from 0.09% to 0.49% for 2-week to 26-week T-bills). Can you guess what “unacceptably low” three and six-month T-bill yields were in the mid-2000s that spawned the birth of the MBS market? Back then, three and six month Treasury bill yields were respectively 2.3% to 4.8%, and 2.6% to 5%. Given that these yields would have to be adjusted for real inflation to compare them to the pathetic Treasury bill yields that exist right now, and given that these exponentially higher yields were unacceptably low back then, can you imagine the type of fraud that might be perpetuated today versus in 2005 and 2006 to capture more yield?
But There are No Similarities to the MBS Market that Collapsed According to the “Experts”
Earlier, I discussed the massive growth of the CLO market in the last two years, from a bit over $616B to over $1 trillion today. During this massive growth, as we can observe in the chart below, the quality of assets that serve as collateral for the CLO market has suffered severe degradation.
So given the above, how can the CLO market narrative be one today of “almost no risk” at a time when risk is soaring? Simply because the ttm CLO default rate has ratcheted down from a much higher 4.1% rate last year to its current 0.5% rate in 2022, analysts have labelled CLO as a completely safe investment with no concern for any of the forward-looking problems I’ve outlined in this article. Even so, one might ask, “How could the last ttm default rate have been reduced to a mere 0.5% given the massive degradation in asset quality displayed in the above chart (that by all available data since Sept 2020, has continued the trend above)?”
The reason for these seemingly disparate, irreconcilable data sets is the ever-changing maturity of the CLO market. Often CLO managers sell lower-rated short-term maturity products in their portfolio and replace them with higher-rated longer-term maturity products. This results in the increasingly higher growth rates in the degradation of asset quality not yielding high default rates in the ttm period by simply pushing the risk down the road. This is how the institutions that shorted the MBS curve decided at what point to short the MBS market by looking at the maturities of the hundreds to thousands of mortgages held in the MBS market and determining when fixed interest rates would convert into variable and therefore cause risk to go ballistic.
And just as no one listened to the sometimes very public warnings of these institutions that shorted the MBS market to the tune of billions back then, no one will listen to anyone issuing warnings about the CLO market today, because the maturity curve of this market will not likely introduce massive risk into this market at least for a couple of more years, likely not until 2024 or so. Thus, everyone will continue to believe the financial industry analysts’ nonsense that the CLO market is as solid as a rock, poses no similar threats to global markets as did the MBS market, and has no risk comparisons to the MBS market of the mid-2000s whatsoever, until the day of reckoning for the CLO market, just as it came for the MBS market, arrives and the CLO market wreaks havoc on the financial system.
And just as occurred with those that were heavily invested in the MBS markets, those heavily invested in the CLO markets will boast about their profits and laugh at those issuing warnings all the way up until the day the entire CLO market quickly turns south. I’ve heard all the arguments that CLOs are not like MBS derivatives, that they are too well structured and managed to create the type of systemic disaster triggered by MBS defaults, and that much lower historical rates and non-existent rates of default respectively among all CLO tranches and AAA-rated tranches of CLOs, and much higher recovery rates for CLOs (about 70% at the end of 2018) versus corporate junk bonds (slightly less than 50% at the end of 2018) prove that CLOs are not MBS derivatives. However, none of these points are valid if the ratings issued by the same ratings agencies that committed fraud during the MBS debacle have repeated this fraud and the same criminal bankers are committing the same crimes today. For their crimes back then in the CDO debacle, agency ratings and bankers hardly took a hit and nobody went to jail.
Same Crooks, Same Roles But Different Expected Outcomes? Really?
For all those that will dismiss this article because of the arguments in the above paragraph, have we forgotten that besides Bernie Madoff, no banker paid for their crimes in any significant manner after the 2008 global financial crisis? If it is in your nature to act like a criminal, and one is never held to any level of accountability for one’s crimes, if you had to bet your life savings, would you bet that these same types of crimes have completely ceased or that they are continuing unchecked? Those that make the argument that CLOs are “nothing like” MBS are making the bet that the crimes have completely ceased.
How quickly we forget the billion dollar Abacus CDO fraud executed by Goldman Sachs bankers in which they sold CDOs as creditworthy and solid to unsuspecting “muppets” (Goldman’s term for their marks in this fraud, not mine) and had hedge fund managers fill the CDO with crappy junk mortgages that the fund managers shorted while Goldman bankers sold them as “safe”. In other words, Goldman bankers marketed the Abacus CDO in exactly the opposite manner to which they knew it to be. For their crimes, they were fined a joke of $550M.
And even though the US Justice Department tried to make a show that they would no longer look the other way in the arena of systemic financial crimes by bringing a $5B lawsuit against credit ratings agency Standard & Poor’s, Standard & Poor’s remained defiant and had the gall to push back against the US Justice Department and called the lawsuit completely “meritless”. In response, as usual, the US Justice Department collapsed like a cheap tent, and levied a paltry $80M fine, reducing its original fine by 98.4%. Though the mass financial media comically publishes headlines of these “huge” and “massive” fines, the fact is that the fines levied by regulators and judicial bodies are always tiny fractions of the profits stolen by these banks in committing their crimes, so thus serve as zero deterrent moving forward in committing similar crimes.
In fact, just a few years later after US regulators fined Goldman Sachs the comical “huge” fine of $550M for committing the Abacus fraud, Goldman participated in one of the most criminal lootings of a sovereign nation’s investment fund, the Malaysian 1MDB fund, in which Goldman bankers criminally took two-hundred times the normal fee, apparently under the supervision of thirty Goldman executives,for a $6.5B bond placement in a fund plagued with corruption. Even worse, according to a Harvard Law Review analysis of this fraud, Goldman’s morally reprehensible bond offerings allowed a corrupt, and very publicly known-to-be-corrupt Prime Minister to remain in power in Malaysia for an additional five years, as their bond placement funded his government. During these additional five years, the corrupt Malaysian PM imprisoned and killed many of his opponents. So thank you, Goldman Sachs, for fighting freedom and doing your part to uphold tyranny around the world. And to squash any notion that criminality is not systemic at Goldman Sachs, the Wall Street Journal reported that then CEO “Mr. Blankfein personally met with the now-imprisoned former Malaysia Prime Minister and his now-fugitive chief alleged co-conspirator, Jho Low, apparently at least twice and maybe more times.”
Conclusion
So I ask you, “Is this the group of people you really want to place your trust in, in declarations that the CLO market is rock-solid and poses no threat to the global financial system today?” Sure, I understand that CLOs only comprised 2% of all US bank assets in mid-2019, and that 2% on the surface, is far too low of a percentage to create systemic havoc. However, we also know that 2% does not represent the total risk of the CLO market for a number of reasons based upon information I’ve already discussed in this article. For example, we know that:
- 2% for the most part represents only a portion of the overall CLO market as banks have limited their CDO investments to the AAA rated tranche. Therefore, the lesser creditworthy portions of the CLO market can still go belly up and create tremendous problems; and
- CLOs are highly leveraged products, so if the highest-rated credit tranches go belly up, that the effect will be magnified through all other tranches and throughout the financial system
Thus, in my opinion, it would be a foolish conclusion, as many analysts are currently concluding, that the low percentage of bank assets invested in CLOs will prevent CLOs, even should they default, from having serious consequences upon global financial health. But hey, what do I know, because all the “experts” are saying the exact opposite.
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