The Rise of CLOs
CLO stands for Collateralized Loan Obligations and they sound eerily similar to what brought down the financial system in 2008 - CDOs (replace the loan with debt). If you just look at the words, you will make no sense of it. (If you do, drop me an email) But actually, it is a pretty easy to understand investment product, and here’s a graphic to help you understand better. (Financial terms tend to be overly-complicated to put people off if you still haven’t get it)
Imagine you have a guy called J Bond. He wants to earn some money, like any of us, so he comes up with an industry-leading, absolutely original product called a CLO. He whips out a magic bottle and goes around the markets, asking banks if they have any loans to sell. He makes a trip and buys all the loans for $10 million and puts it inside his bottle. Now, the thing about loans is that they have interest payments. So every month, Bond gets coupon payments. But he is not happy - he thinks those payments aren’t enough and he wants to earn more! So what he does is he split up the coupon payments every month into segments - bankers use the word ‘tranches’ to describe them to confuse us even more. Each tranche is like a layer in those wine fountains you see on the internet but never in real-life - the smaller, upper layers are of better grade and receive the coupon payments first, but as a penalty, those cups are smaller and get less wine (lower payments). Those at the bottom, because they receive the payments last (if there are still any money left to reach the bottom), are compensated with higher interest. Each of these wine cups are then sold to other investors, they could be institutions, pension funds, ETFs, all sorts of people and J Bond earns the nice commission he charges for thinking of this great idea and putting it together.
Wait, Isn’t Money Just Flowing From One Place To Another?
Yep, that’s absolutely correct. This is basically the economy in a very cynical nutshell. But imagine for a moment J Bond and his magic bottle dosen’t exist. Nobody will buy these loans. Banks, who usually give out loans, will find that they have so many loans on their balance sheets but nobody is willing to take them off their hands. This means they have less money to lend to other people and make money and people who need loans to grow may not be able to get money (think business owners or corporations). CLOs serve a justifiably useful role - they provide liquidity to the economy by freeing banks from their liabilities and offer more investment choices for investors out there.
Wait, Didn’t CDOs Bring Down The Economy?
Yep, that’s absolutely correct. CDOs, in principle similar to CLOs but with the magic bottle filled with mortgages instead, were the root cause behind the 2008 financial crisis. Basically, banks got high on their own supply (they bought CDOs when in principle, they should be selling the mortgages that made up CDOs and then stopping right there), and when too many homeowners (for the time being) lost their ability to pay the loans, caused a massive domino effect to ripple through the banks and everybody else that relies on them, collapsing the financial system. The main takeaway here is CDOs in principle are benign, only if it serves it purpose and people do not get too greedy and overexpose themselves to such risks such as buying them.
Wait, So CDOs Are Back But In Another Form?
Yes, that’s somewhat correct. The nature of the underlying loans are different but the idea is similar. From 2007 to 2019, according to S&P Global, the value of outstanding leveraged loans (which form the bulk of CLOs) rose from $554 billion to $1.2 trillion. It is a psychology game. As time passes, people forget the pain of the previous disaster and old habits claw back at them, urging them to take on ever more risk to find ways to earn more money. Now, with the economic downturn due to the batman virus, the fate of these bonds are thrown back into the spotlight. In April 2020, 11 companies who issued these leveraged loans filed for bankruptcy protection - the highest number in a month ever since a record of 10 in October 2009 - according to S&P Global, again. Rising defaults is simply going to become a norm in the upcoming months ahead as people are cooped up at home and demand for goods & services are insanely low; And if people’s greed does not push us over the edge, the microorganisms may very well do so.
Wait, Isn’t There At Least Something To Be Grateful For?
Yes, there is thankfully. Compared to the 2000s, banks now are less leveraged thanks to steeper capital adequacy requirements post 2008. This means that if all hell breaks loose, by definition, they will have sufficient reserves to take on the losses and they will not drag everyone else down with them. Also, the Federal Reserve seems to have acknowledged that bad loans may be a problem and will actively buy corporate, non-financial companies’, loans to deleverage the problem. But, there is a but, the Fed seems to only target large investment-grade firms like Ford, and many middle firms and small firms, who also own a sizeable amount of risky loans, are left to fend for themselves (and be killed off in the process).
Wait, So What Is The Takeaway?
The takeaway is this. Read more and think through those information critically in whatever financial or non-financial decision you make. I wish the future is predictable but it isn’t. The best we can do is to make the most rational and least emotional choice we can with the limited knowledge that we have. After that, we can just hope for the best.