Secured Loan Bonds (CLOs), which bundle and sell corporate debt to investors, are increasingly seen as a major threat to the U.S. financial system. However, such concerns “are misplaced, driven by a misunderstanding of CLOs and their role in the banking system,” Wharton finance professors Michael R. Roberts and Michael Schwert write in this opinion piece.
In recent times, Secured Loan Bonds (CLOs) have received a lot of negative attention. At first glance, they look a lot like the Secured Debt Securities (CDOs) that precipitated the 2008 financial crisis. Additionally, US banks have over $ 100 billion in investments in CLOs.
However, concerns about the impact of CLOs on the financial system are misplaced, driven by a poor understanding of CLOs and their role in the banking system. There are reasons to be concerned about business loans during the COVID-19 pandemic. A financial system collapse caused by a familiar acronym is not one of them.
CLO vs. CDO
Like CDOs, CLOs buy risky loans with money received from different groups of investors. Interest and principal payments on the loans are then distributed to CLO investors in a specific order: senior investors are paid first, junior investors next, and equity investors last.
Any missed loan payment results in reduced payments to CLO investors, but in reverse order: equity absorbs losses first, then junior investors, and finally senior investors. It is only after stocks and junior investors are eliminated that senior investors suffer a loss. Therefore, CLO claims held by senior investors are usually rated AAA (i.e. very secure) because many loans have to go bad before they lose money. Junior tranches receive a lower rating range proportional to their risk, and equity tranches are unrated.
This is where the similarities end.
A study by Cordell, Feldberg and Sass (2019) shows that AAA-rated CDO tranches issued before the 2008 crisis lost $ 325 billion in subsequent years. In contrast, Standard and Poor’s found that AAA rated CLO tranches issued before the 2008 crisis lost nothing. This performance differential stems from the differences in the assets that the two vehicles purchased.
CDOs struggling during the financial crisis did not buy loans, they bought junior tranches of other CDOs (mortgage-backed securities) and credit default swaps (derivatives) referencing other CDOs. The process of repackaging CDO tranches into new CDOs greatly amplifies the risk, which is why senior investors in these products have lost so much money.
The typical CLO holds hundreds of diverse loans in dozens of industries. Exposure to any industry is contractually limited to 15% of the loan portfolio, while maximum exposure to a single company is 2%. Thus, defaults must be ubiquitous in all sectors of the economy to materially affect the collateral pools of the CLOs.
Unfortunately, that is exactly what is happening now. Most sectors of the economy are experiencing varying degrees of unrest. In addition, credit granting standards have been falling for several years, weakening creditors’ protections. The combination raises the possibility that CLOs will experience significant losses in the coming months.
But will these losses reach senior investors, who are mainly banks and insurance companies? Even under the most pessimistic economic forecasts, this is unlikely.
“The process of repackaging CDO tranches into new CDOs dramatically amplifies the risk, which is why senior investors in these products have lost so much money.”
If lenders recoup $ 0.40 on a dollar for defaulted loans, 60% of the loans in CLO portfolios would have to default before the AAA rated tranches even start losing money. To put this number into context, the cumulative default rate for risky debt during the worst three years of the Great Depression (1931-1933) was 31%.
If AAA rated CLO investments fail in large numbers, then the business sector will face the worst recession in our country’s history. The CLOs will be the least of our concerns.
The risk for banks
Despite the low probability, what if the banks’ CLO investments default? Will these defaults create problems for the banking system? No.
U.S. banks hold $ 104 billion in investments in CLOs, of which $ 83 billion is on the balance sheets of three banks: JPMorgan Chase, Wells Fargo and Citigroup. As a fraction of their assets, CLO investments are 1.1%, 1.3% and 0.9% respectively. As a fraction of Tier 1 capital, which regulators use to measure a bank’s ability to resist losses, CLO investments are 17%, 17%, and 14%, respectively.
If every loan from every CLO defaulted at the same time and all the assets backing those loans evaporated into the air so that lenders could not get any money back, these three banks would still be left with over 80% of their equity . , or more than $ 400 billion.
This is not to say that the banking system is immune to risks, including that of risky business loans. Business failures would affect banks in several ways beyond their investments in CLOs. But the view that CLOs are analogous to CDOs of 2008, and therefore will be the cause of our next financial crisis, does not match the facts as they stand today.