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Could Collateralized Loan Obligations Trigger The Next Financial Crisis?

Could Collateralized Loan Obligations Trigger The Next Financial Crisis?

One of the silver linings of the 2020 economic downturn is that so far, unlike in 2008, the global financial system does not appear to be in immediate danger. However, in his daily newsletter last week, Whitney Tilson said there's something threatening the stability of global banks in 2020 as well.

CDOs Vs. CLOs: During the financial crisis in 2008 and 2009, one of the biggest risks to the stability of the financial system was the collapse in collateralized debt obligations, or CDOs. At the time, these CDOs were constructed from collections of mortgage bonds. Despite receiving credit ratings of AAA from the ratings agencies, many of these CDOs were constructed from low-quality subprime mortgages, which ultimately collapsed during the burning of the housing bubble.

Tilson said there is a similar situation occurring with collateralized loan obligations, or CLOs. Instead of mortgage bonds, CLOs are constructed from corporate loans.

“The CLO market has exploded in the past decade... It's a byproduct of the boom in private equity, which layers tons of debt onto its acquisitions,” Tilson said.

Banks Exposed: The extended period of low interest rates has pushed banks to get more aggressive in their corporate lending strategies over the years.

“CLOs should work well for the banks, unless – like with mortgages in 2008 – all the loans go bad at the same time,” Tilson wrote.

As of 2018, the Bank for International Settlements estimated $250 billion of the $750 billion global CLO market was sitting on the balance sheets of big banks. UC Berkeley law professor Frank Partnoy estimates Wells Fargo & Co (NYSE: WFC) holds $37 billion in CLOs, JPMorgan Chase & Co. (NYSE: JPM) owns $35 billion in CLOs and Citigroup Inc (NYSE: C) owns $20 billion in CLOs. Unfortunately, as investors learned in 2008, these bank balance sheets are notoriously unclear.

At the same time banks are exposed to the CLO market, insurance companies are exposed as well. In fact, the U.S. insurance industry has about $158 billion in collective CLO exposure, according to Tilson.

Fitch recently estimated about 82% of the corporate debt backing the CLOs themselves is B-rated or lower.

The Good News: Tilson said the good news for investors is that the AA-rated tranches of the CLO market still appear to be a long way from danger. There are two key distinctions between the CLO market today and the CDO market in 2008. First, many of the mortgages backing the CDO market in 2008 were simply fraudulent.

“Loans were granted to consumers based on income and other data that were simply made up. No evidence exists that corporate loans have been systemically rated too highly in a similar way,” Tilson said.

In addition, Tilson said there should be much lower correlation among the corporate bonds backing today’s CLO market than there was among the mortgages backing the CDO market in 2008. Corporate bonds come from a wide range of different sectors and industries, helping create more diversification within the CLO market.

Benzinga’s Take: One of the reasons the SPDR S&P 500 ETF Trust (NYSE: SPY) has been so resilient throughout the severe economic slowdown triggered by COVID-19 is because of the tremendous amount of debt the U.S. government has taken on and the massive amount of debt U.S. corporations have added to their balance sheets to combat the recession.

Concern about the stability of the CLO market is just one of the questions being raised by investors worried about the potential long-term fallout from such heavy reliance on debt.

Do you agree with this take? Email with your thoughts.

Related Links:

What Does A 'Second Wave' Of COVID-19 Mean For Investors?

How The COVID-19 Drop Has Potentially Set Up 'Another Long Economic Expansion'

Latest Ratings for JPM

Jul 2020Atlantic EquitiesUpgradesNeutralOverweight
Jul 2020Wolfe ResearchUpgradesPeer PerformOutperform
Jul 2020DA DavidsonUpgradesNeutralBuy

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