A recent article by Frank Partnoy of The Atlantic shed light on another disturbing financial reality that’s sure to lend deja vu. Fresh on the heels of the 2008 housing market crash and the misguided trading of CDOs, big banks have spun up a new financial vehicle, called a CLO, and are jamming their balance sheets chock-full with them.
So, what is a CLO? And for that matter, what’s a CDO?
CDO stands for Collateralized Debt Obligation, and is a packaged security made of loans to home buyers. Theoretically, CDOs were designed to take risk away from the bank, by not having them directly downstream of potential defaults on the loans within the CDO. And practically, this worked, at least until the banks started making big bets on the CDOs through use of complex financial techniques that were largely hidden from the public.
Thus, when the economy took a hit these banks were hit twice as hard, requiring government bailouts across the board. This worked, and the economy quickly righted itself to begin the longest running bull market in 2009. Of note, America wasn’t dealing with record unemployment, a global pandemic, and widespread social unrest in 2009.
To prevent such misguided, foaming-at-the-mouth greedy trading of CDOs from happening again, Congress passed the Dodd-Frank Act in 2010. Under its litigation, banks were directed to borrow less, be more transparent about their holdings, and take less risky bets. Attempts were also made to reform credit rating agencies, who many blame as the catalyst of the financial crisis.
You see, leading up to the events of 2007 and 2008, credit rating agencies were trusted with the task of correctly assigning values of confidence to CDOs, and the qualifications of the borrowers therein.
A CDO with high marks implied prime loans with qualified borrowers, ensuring a relatively risk-free financial vehicle.
In reality, credit rating agencies were slapping AAA ratings on woefully subprime loans with borrowers that fit no definition of ‘creditworthy’, analogous to Santa Claus losing any sense of morality and flinging gifts willy-nilly. Over the course of the financial crisis, 13,000 AAA CDOs that were given minimal odds of defaulting, defaulted.
In The Big Short, a film that deserves mandatory viewership, a stripper from a podunk Florida town was granted four mortgages, with little to know credit checking. And somehow, the financial world thought, “Yeah, that’ll work!”
Fast forward to 2020. CDOs have died off, and CLOs have risen from the ashes.
CLO stands for collateralized loan obligation, and are packaged securities made of loans to business. If you’re thinking, “That sounds an awful lot like a CDO,” you hit the nail on the head.
CLOs specifically target deprecated businesses, to the extent that they’ve maxed out their borrowing, and are unable to obtain traditional bank loans or sell bonds directly to investors. These are more commonly referred to as leveraged loans.
As of recent reports, there’s more than $1 trillion worth of leveraged loans outstanding, in a time when many small businesses are already waiting for the government to spoon feed them.
What I’m trying to say is that these CLOs are groups of loans made to struggling businesses before Coronavirus shut down the economy and put even healthy businesses on life support.
If there was any real chance of the subprime loans in CLOs being repaid pre-COVID, there’s significantly less now.
Meaning what? Big banks that are heavily invested in CLOs are likely facing massive defaults, which will require major federal bailouts.
So, what banks are tasting of the forbidden fruit? Frank Partnoy took a deep dive into Wells Fargo, where he has a checking account and home mortgage. Deep in the bowels of Wells’ annual report is an entry for “collateralized loans and other obligations” — CLOs. The amount?
$29.7 billion.
Inside the bank, too, when they were specifically designed to reside outside the bank.
Last December, the Financial Stability Board reported that, for the “30 global systemically important” banks, the average involvement in leveraged loans and CLOs was roughly 60% of cash on hand.
Yikes.
What’s more, Citigroup reported $20 billion of CLOs as of March 31st, with JP Morgan Chase checking in at $35 billion. Several midsize banks, such as Stifel Financial and Banc of California, report CLO holdings totalling more than 100% of their capital.
And in case there was any chance you would sleep tonight, the CLO defaults have already begun. “There were more in April than ever before. Several experts told me they expect more record-breaking months this summer. It will only get worse from here.”
The full extent of this potential crisis will take time to be fully realized. This economic environment is roughly equivalent to the Summer of 2007, where defaults were in their infancy, and the full plunge transpired in Fall of 2008. The Dodd-Frank Act will ensure that banks are not completely inundated by CLO defaults, but the strain of compounded economic debilitations will lead to increasing capital deficits.
Faltering banks, already strained to meet the incumbent demands of our current recession, will fail. American citizens may struggle to buy a new car, mortgage a home, or pay student debt.
I only hope that on the other side of this, stronger litigation will be put in place to require strict transparency among banks and their holdings, and consequences will be enacted that inspire healthy fear of economic malpractice, and quench the thirst of greed.