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Who Will Get Hit When Collateralized Loan Obligations (CLOs) Blow Up? Banks or Unsuspecting “Market Participants”?

Who Will Get Hit When Collateralized Loan Obligations (CLOs) Blow Up? Banks or Unsuspecting “Market Participants”?

Answers emerge from the murky business of CLOs.

There has been quite some hoopla surrounding Collateralized Loan obligations (CLOs) because the underlying leveraged loans – junk-rated loans often used by private equity firms to fund leveraged buyouts (LBO) and other high-risk endeavors such as special dividends – are now starting to come apart. There are approximately $700 billion in US-issued CLOs outstanding.

US banks hold $99 billion of these CLOs, according to S&P Global Market Intelligence. The rest are held by various institutional investors, such as insurance companies, pension funds, mutual funds, hedge funds, private equity firms, and the like. They’re also held by entities overseas, including certain banks in Japan that have gorged on these US CLOs. But that’s their problem.

One third of the CLOs in the US banking system are held by just one bank: JPMorgan Chase; and 80% of the CLOs in the US banking system are held by just three banks. But at each of these three gigantic banks, CLOs account for only 1.2% to 1.3% of total assets (total asset amounts per Federal Reserve Q1 2020):

  • JPMorgan Chase: $34.0 billion in CLOs = 1.3% of its $2.69 trillion in assets.
  • Wells Fargo: $24.6 billion in CLOs = 1.2% of its $1.76 trillion in assets.
  • Citigroup: $21.4 billion in CLOs = 1.3% of its $1.63 trillion in assets.

In 11th position down the list is the second largest bank in the US, Bank of America, with just $807 million in CLOs, accounting for barely over 0% of its $2.03 trillion in assets.

In other words, the largest four banks in the US hold $81 billion of the $99 billion of CLOs in the US banking system – but given the gargantuan size of their assets, this percentage-wise small CLO exposure is the least of their problems.

…click on the above link to read the rest of the article…

Satyajit Das: The CDO Bomb That Blew Up In 2008? There Is A New One

Satyajit Das: The CDO Bomb That Blew Up In 2008? There Is A New One

In recent months, with the investor spotlight increasingly falling on the “leveraged loan problem”, or the fact that there are now more leveraged loans outstanding – most of them offering virtually no covenant protection to investors and effectively stripping them of their “secured” position in the capitalization waterfall thus making them pari passu with high yield debt – than junk bonds, there has been a resurgence of discussions whether CLOs are the next “ticking timebomb”, and whether Collateralized Loan Obligations which have emerged as the primary source of demand for new loan issuance, will be the new CDOs and catalyze a systemic crash.

In an attempt to short-circuit such concerns, two weeks ago Barclays published a “CLO mythbuster” piece, in which it first noted that since 2008, Bloomberg, the Financial Times and even Hollywood have provided the general public with myriad causes of the Great Financial Crisis (GFC), “rarely failing to include a layman’s introduction to CDOs and how they played a major role”, and noting that “more recently, this conversation has grown to include comparisons to today’s CLO and leveraged loan markets, with premonitions of another GFC brewing just a decade after the last with CLOs acting as an accelerant.”

But first, this is Barclays defines a CDO in general, and a CLO in particular:

The term CDO actually covers an array of structured vehicles backed by debt, whether that debt is leveraged loans (CLOs), high-yield bonds (CBOs) or even other structured products (CDO-squared). So, while CDO subsets may have somewhat comparable structures (an SPV issues debt tranches, AAA through equity, and buys assets), the performance of the underlying assets and the ability for the vehicles’ liabilities to match the cash flows generated by those assets have proved vital for the future performance prospects of structured products.

 …click on the above link to read the rest of the article…

Looking for the Next Crisis: the Not Very Scary World of CLOs

Looking for the Next Crisis: the Not Very Scary World of CLOs

We’re still in financial crisis mania, as the business press eagerly tries to tell us how little they learned from the last crisis by trying to identify the source of the next one. The NYT’s latest contribution to the effort is a piece on C.L.O.s, or collateralized loan obligations.

The piece tells us that these are like the C.D.O.s of the last decade, debt instruments in which banks bundled many loans of questionable quality and sold them off to unsuspecting buyers. It warns that banks have little incentive to ensure their quality, since they don’t hold a stake, and therefore there is a risk of large-scale defaults.

There are two big problems with the scare story here. First, the growth in these risky instruments is not quite what the piece might have readers believe. The piece includes a chart which shows the amount of junk bonds and C.L.O.s outstanding since 2014. While the point of the chart is to show that volume C.L.O.s has passed the volume of outstanding junk bond debt, a more serious analysis would combine the two together to get a gage of the amount of high-risk corporate debt in the economy.

This combined measure does not tell much of a story. Eyeballing the chart, we go from a combined total of roughly $1.95 trillion in 2014 to $2.5 trillion in the middle of 2018. Since this is a period in which the economy has grown by roughly 20 percent in nominal terms, this indicates only a modest rise in the ratio of risky corporate debt to GDP. This is not the sort of stuff that need keep us awake at night.

…click on the above link to read the rest of the article…

Business Cycles and Inflation, Part II

Early Warning Signals in a Fragile System

[ed note: here is Part 1; if you have missed it, best go there and start reading from the beginning]

We recently received the following charts via email with a query whether they should worry stock market investors. They show two short term interest rates, namely the 2-year t-note yield and 3 month t-bill discount rate. Evidently the moves in short term rates over the past ~18 – 24 months were quite large, even if their absolute levels remain historically low.

Sizable moves higher in short term interest rates were recorded over the past two years. 2 year note yields only started moving up in mid 2016, but the surge in t-bill discount rates has been in train since late 2015 already. The moves in short term rates come from extremely low levels, but they are nevertheless quite noteworthy – click to enlarge.

The first thing that comes to mind in connection with asset prices is that the cost of carry for leveraged positions is rising. Eventually this will have an effect on such positions, particularly in fixed-income instruments, which inter alia include structured products such as CLOs (collateralized loan obligations). Some market participants reportedly employ leverage of up to 1:10 in these in order to boost returns, which the banks are apparently happy to provide, as the risk is deemed to be low.

As we have discussed previously, CLOs are conceptually not different from the CMOs that created such heavy conniptions in 2007-2009, but CLOs ultimately turned out to be quite resilient at the time. The problem is of course that it is definitely not a given that they will be similarly resilient in the next crisis.

…click on the above link to read the rest of the article…

Olduvai IV: Courage
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Olduvai II: Exodus
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