CDOs, or \”collateralized debt obligations,\” were at the heart of what broke down in the US financial system and helped put the \”Great\” in the \”Great Recession.\” Is there another financial instrument out there that raises similar concerns? CLOs, or \”collateralized loan obligations,\” have a similar structure and have now reached a similar size to the CDOs circa 2008.
How much should we be worried? As I\’ve noted in past discussions of the subject, several Fed officials including Lael Brainerd of the Fed Board of Governors and Robert Kaplan of the Federal Reserve Bank of Dallas (who will rotate on to the membership of the Federal Open Market Committee in 2020) have raised concerns. Sirio Aramonte and Fernando Avalos offer a nice short discussion of this comparison in \”Structured finance then and now: a comparison of CDOs and CLOs,\” which appears in the BIS Quarterly Review (September 2019, pp. 11-14). They write: \”The rapid growth of leveraged finance and CLOs has parallels with developments in the US subprime mortgage market and CDOs during the run-up to the GFC. We examine the CLO market in light of that earlier experience.\”
Here\’s some backstory. The collateralized debt obligation of concern back in 2007 were a set of financial securities that were based on pools of subprime mortgages. There\’s nothing wrong with collecting mortgages into a pool, packaging them into a security, and then reselling them to investors like insurance companies, pension funds, hedge funds, and banks.
But the problem with creating a financial security based on subprime mortgages was that–by the definition of \”subprime\”–a relatively high percentage of these mortgage were going to default, so a financial security based on these subprime mortgages would be fairly risky. For example, banks would not be allowed by regulators to hold such securities. However, some financial wizardry solved that problem. The CDOs were divided up into sections, called \”tranches,\” with some of the tranches being very risky and some being very safe. For example, if losses on the underlying subprime mortgages were in the range of 0-10%, then all of those losses would fall on one set of investors in the highest-risk tranche. If losses on the underlying subprime mortgages fell in the range of 10-20%, then those losses would fall entirely on another set of investors in the next highest-risk tranche. With several of these tiers built into place, so that any losses would be concentrates on a subset of investors, the other tranches of the CDO appeared to be very safe: indeed, those tranches were rated AAA and banks were allowed to hold them.
The current wave of collateralized loan obligations are also financial securities based on pools of debt–but in this case, the debts are corporate loans rather than subprime mortgages. Again, there\’;s nothing wrong with collecting debt into a pool, packaging it into a security, and reselling it to investors. This kind of corporate debt is called \”leveraged loan.\” As Aramonte and Avalos write:
CDOs and CLOs are asset-backed securities (ABS) that invest in pools of illiquid assets and convert them into marketable securities. They are structured in tranches, each with claims of different seniority over the cash flows from the underlying assets. The most junior or so-called equity tranche is often unrated and earns the highest yields, but is the first to absorb credit losses. The most senior tranche, which is often rated AAA, receives the lowest yields but is the last to absorb losses. In between are mezzanine tranches, usually rated from BB to AA, which start to absorb credit losses once the equity tranche is wiped out. The larger the share of junior tranches in the capital structure of the pool, the more protected the senior tranche (for a given level of portfolio credit risk).
For both CDOs and CLOs, strong investor demand led to a deterioration in underwriting standards. For example, US subprime mortgages without full documentation of borrowers’ income increased from about 28% in 2001 to more than 50% in 2006. Likewise, leveraged loans without maintenance covenants increased from 20% in 2012 to 80% in 2018. In recent years, the share of low-rated (B–) leveraged loans in CLOs has nearly doubled to 18%, and the debt-to-earnings ratio of leveraged borrowers has risen steadily. Weak underwriting standards can reduce the likelihood of defaults in the short run but increase the potential credit losses when a default eventually occurs.