The next big short, a new financial house of cards that threatens to implode the global economy, is here. Though this article is a bit premature (I’ll discuss why in Part II of this article), it still deserves a lot of attention at the current time because if no regulatory measures in this market are taken, it will eventually implode the economy. This take is an unpopular one among most financial analysts that have analyzed this market. But all my takes are almost universally unpopular with analysts. However, lack of popularity or lack of imminent manifestation (and I’ll explain later in this article why my take is not likely to manifest for another couple years) does not make it wrong. Many of my opposition takes, like Wall Street bankers were manipulating gold and silver prices lower, have taken years to prove, with JP Morgan, Barclays, Deutsche Bank bankers finally admitting in court their role in manipulating gold prices lower literally more than a decade after I made such claims.
What are CLOs?
CLOs, Collateralized Loan Obligations that consist of a pool of leveraged loans from bank syndicates collateralize by corporate junk bonds, asset-backed securities (ABS), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and other CDOs and CLOs, is the next big short. However after the 2008 financial crisis, around 2014 or so, in an effort to strengthen the collateral backing CLOs, corporate junk bonds were eliminated as acceptable collateral for CLOs. In addition, efforts to truly diversify CLO collateral with loans from an assortment of industries occurred, unlike the comical “diversification” of MBSs that took place in the mid-2000s when diversification of junk-rated mortgages from different banks earned MBS products AAA credit ratings. As well, efforts were made to limit junk-rated CCC debt to just a 5% to 7.5% tranche of the overall CLO collateral.
But, as there always is a valid “but”, when analyzing risk in financial products, as always happens over time, bankers pushed to embed more and more risk into the CLO market as they sought higher payouts, and some of the protective aspects of CLOs put in place after the 2008 financial crisis have already been largely eroded. For example, the tranche of loans rated CCC or lower increased from the once maximum level of 5% to 7.5%, to 10% or more, by 2020. Secondly, to state that these levels are accurate must assume that credit ratings are now being dispensed legitimately versus the fraudulent ratings dispensed across the board by US ratings agencies in the mid-2000s. And this is an assumption I definitely am unwilling to make.
The Composition and Structure of CLOs
CLOs use funds received from the issuance of debt and equity to acquire a diverse portfolio of senior secured bank loans. The debt issued by CLOs is divided into separate tranches, each of which has a different risk/return profile based on its priority of claims on cash flows produced by the underlying loan pool. Financial companies purchase senior secured bank loans from a diverse range of borrowers, typically 150–250 companies, pool them together in one CLO offering and assign a manager to actively manage it. Put as simply as possible, the vast majority of CLOs are cash-flow driven products in which principal and interest payments from the collateral pool of leveraged loans flow to service the debt due to debt holders and equity investors.
The Maturation Cycle of CLOs
The level of risk of a CLO also depends upon how risk is actively managed by the CLO manager and the stage of maturity of the CLO. An initial structuring period of three to six months exists, in which bank loans that serve as collateral must be purchased. After this, a follow-up period of two to five years in which the quality and maturity of the underlying collateral is actively managed occurs. And the final stage of a CLO consists of a wind-down (amortization) period in which the manager pays off senior debt (AAA/AA) first, followed by subordinated (A/BBB/BB/B/CCC/CC/C) debt next, and then distribution of final proceeds distributed to equity investors. Over time, in an attempt to reduce risk, CLO managers have shorted the cycle by a few years from a previous average maturation cycle of eight to ten years.
And although other caveats exist that can shorten the maturation cycle even further, for example, the “calling” a CLO in which it will be terminated in an earlier time frame, the above explains the life cycle of CLOs as simply as I can explain it. However, as always happens in the financial world, most times when developments occur to reduce risk, since reduced risk means reduced yield, other developments occur which neutralize such risk reduction rules. In February 2018, the rule that subjected CLO managers in broadly syndicated loan (BSL) structures to own 5% interest in the total CLO structure was revoked, basically nullifying much of the aforementioned positive impact of an implemented average shorter maturity cycle. Once managers do not have to have any “skin” in the game, usually they ratchet risk significantly higher in search of higher yields and higher payouts to themselves.
The CLO Conundrum
Here’s an interesting conundrum to solve. Typically interest rates on CLO debt is floating, meaning that in an rising interest rate environment, the risk of CLOs will skyrocket, much as risk in MBS derivatives skyrocketed when fixed rates ended and became variable in the mid-2000s. So how do bank analysts reconcile the fact that some of their analysts have predicted seven increases in the Fed Funds rate this year alone, but yet other analysts from the same bank have stated that CLOs are rock solid, low-risk, high-yield investments? Of these two outlooks, one has to be wrong. And the fact that sometimes analysts that work for the same bank provide outlooks in direct contradiction to each other suggest that they do not even challenge each other’s theses.
Generally, when demand outpaces supply in a particular market, as has been the case in the CLO market as of late, overlap of the collateral pool will increase across CLO offerings and diversity decreases. This means that the explosion of the CLO market as of late increases the likelihood of a “domino effect” should a CLO defaults. Consequently, this raises the risk that should a few CLO products default, these few defaults will trigger the simultaneous implosion of many CLO products, and perhaps rapidly devolve into a “rock solid” asset class into systemic tragedy very rapidly, as happened with mortgage-backed securities.
Do Historically Low CLO Default Rates Mean They Are “Safe”?
Unlike commonly thought, CLOs are not a new product, as banks introduced them in the late 1980s. However, their popularity as an investment product has exploded in enormous growth in recent years. Recently, many reports on mass financial media have framed CLOs as “safe” and as presenting nowhere the risk of MBS derivatives that collapsed in the mid-2000s. Part of the reason CLOs are universally lauded by financial analysts as “safe” is because they were projected in late 2020, to possess increasingly higher default rates, as illustrated above, but this higher projection of default rates have not manifested. However, as I just explained above, this low default rate definitively does not mean CLOs are a “no-default” product, as the default rate most often quoted for CLOs is the ttm default rate, or a trailing twelve month default rate. Despite the achievement of extremely low ttm default rates in the CLO market, like the 0.5% ttm default rate just reported this month, this rate is extremely misleading as a representation of risk inherent in CLOs today as it is a backward-looking metric.
Furthermore, every risky individual bank loan that is sold by a banker is merely shifted to another player in the financial industry in a game of CLO musical chairs as a risky individual loan must be purchased by someone else, and the risk held until the loan matures. Therefore, even if a manager decreases the risk of an individual CLO, the risk is merely transferred to another player, and therefore, everything can look solid in the CLO market, until the risk rears its ugly head in another sector of the leveraged loan market. In addition, as I explained above, due to high correlation of risk in individual CLOs when demand outstrips supply, everything can look fine in the CLO market as it did in the MBS market, until it doesn’t.
And even though banks were limited to buying only the AAA-rated tranches of CLOs that have seniority in ranking of claims on cash flows that pay off the CLOs’ debt, the assumption that this vastly reduces risk in the banking industry is based upon the very questionable assumption that rating agencies’ assignment of AAA-credit ratings are not completely worthless, as they were in the early 2000s in the MBS market.
Why the CDO Market Really Has Not Changed, Whether in the MBS or CLO Markets
Before I continue, let’s quickly review how CDOs like MBS derivatives would have collapsed the global financial system had the US Central Bank not bailed out the biggest financial companies on planet Earth to the tune of tens of trillions of dollars. Despite this bailout, in 2008 and 2009 alone, nearly 6% of employed Americans, or 9 million, lost their jobs, and the CDO fiasco destroyed nearly $13 trillion in US household net worth, created a 30% drop in US housing prices and contributed to a 53% destruction in market cap of the US stock market in its aftermath. In 2008, CDOs could possess as little as ½% to 1% of equity for a 100X to 200X leverage ratio, yet still receive the highest credit ratings possible from The Big Three – Standard & Poors, Moodys and Fitch.
Had the US Central Bank not bailed out commercial banks by tens of trillions of dollars back then, it is very unlikely that the CLO market would have grown as quickly as it has. Had regulators and Central Bankers actually held commercial bankers and rating agency employees that nearly collapsed the global economy through unethical and irresponsible behavior during the early 2000s in the MBS markets to any type of accountability after the 2008 global financial crisis, they wouldn’t have been emboldened to repeat this behavior in the development of the CLO market.
Even though it’s been repeatedly falsely claimed by some analysts that lessons from the 2008 MBS collapse have manifested in a massive shrinkage of the CDO market from nearly half a trillion dollars in 2006 to just $126B in 2020, bankers have merely hidden the massive growth of the risky CDO market since the 2008 financial crisis by repackaging the same risky CDO products in different names that exclude them from being included in overall CDO data reported today. Analysts love to reference the below chart to falsely conclude that the CDO market has collapsed since the 2008 global financial crisis, and therefore the level of threat from the CDO market has practically disappeared.
However, that conclusion would be wrong. For example, CLOs are definitely a form of CDOs as are BTOs (Bespoke Tranche Opportunities), but neither are included in the CDO market size. Furthermore, BTOs are simply rated by the issuer and do not even receive credit agency ratings, though I’m not sure that the obvious bias of the issuer to rate BTOs in higher credit categories than they deserve would differ much from ratings issued them by credit agencies.
Anytime a Market Grows This Explosively, Accurate Risk Ratings Are Going to Fail Simply Due to Risk Assessors Being Inadequate to Meet Demand
One year after the MBS fiasco in 2008, the size of the CLO market was practically zero. However, by 2018, the CLO market had grown to $125B new issuances per year, a growth rate that was greater than auto loans, and credit cards, equipment loans and student loans combined. By the end of November 2018, the CLO market had grown by 760% in 18 years to $616B. From the end of 2018 to the end of 2020, the growth continued to soar, and the CLO market grew an astonishing additional 60% in just two more years to over a trillion dollars. As usual, with derivative products, the US dominates the CLO market, with the US capturing 80% of the total CLO market, and Europe capturing the rest.
By, 2021, Global Capital Securitization estimated that new CLO growth and issuance continued, at $300B to $330B annually. According to Bank of America, US bank ownership of CLOs has exploded along with its market growth. By Q1 2021, US bank ownership of CLOs was skyrocketing 20% qoq to $120B as opposed to a 12% decline in CLO ownership to $100B by the typical largest banking players in the market, the Japanese. And even though many banks have limited the bulk of their purchases to AAA rated CLOs, the fact that the exact same players that were involved in the fraudulent creation and ratings of the MBS market have been involved in structuring and rating CLOs, what is your confidence level that AAA rated CLOs really consist of low-risk loans?
In my opinion, the potential problems of the CLO market to explode from single institution problems rapidly to systemic-wide problems, as I’ve outlined in this article, make the potential of CLOs to take down the global economy every bit as problematic as the MBS markets in the early 2000s. In mid-2019, US banks held only about 13% of the then $700B market cap of CLOs, with money managers, insurance companies and pension funds holding the rest. By all reports, bankers, in their never-ending search for additional yield in a sea of increasingly lower yield Treasury bills, have become even larger players in the $1 trillion plus sized market today.
Coming soon: The Next Big Short, Part II: The Similarities Between MBS and CLO Markets; the Massive Degradation of CLO Collateral; Same Crooks, Same Roles, Different Product; and The Conclusion
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