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CLOs deserve a fair trial

By Tom Brown
19 Nov 2019

Collateralised loan obligations (CLOs) are on trial with regulators and central banks around the world, standing accused of being the financial instrument most likely to cause the next financial crisis. The prosecution, however, needs to look at the the facts.

It has become increasingly difficult to open up a financial newspaper of late without running into some discussion of the dangers that CLOs pose to society. The Bank of England (BoE), the Bank of Japan, and the Financial Stability Board have all launched investigations into the asset class this year.

They are often described as the “cousins of CDOs” or as resembling “other structures that rocked the financial system a decade ago”, leaving many unsuspecting CLO managers groaning over how much time they will have to set aside to explain the difference to those outside the market.

The only thing that CLOs have in common with CDOs is that they are structured. CLOs are comprised of leveraged loans sliced into tranches that pay investors more, or less, depending on the risk they are comfortable with. The CDOs that drove the financial crisis, on the other hand, were resecuritizations of existing tranches — usually the triple-B rated bits of mortgage-backed securities, rebadged as a triple-A rated investment. This was fundamentally fraudulent, as evidenced by the $1.375bn pay-out won by the US Department of Justice from Standard & Poor’s because of how the agency rated the products.

There was no such payout over CLOs. But for many commentators and regulators the similarity seems obvious: one was a package of dodgy mortgages — which blew up the financial world a decade ago — and the other is a package of dodgy leveraged loans.

The caution is understandable. The financial crisis cast a long shadow and everyone is keen to avoid a repeat. With credit cycle perhaps starting to turn, it is perhaps natural that CLOs fall under the microscope.

Out with the old

But scrutiny of CLOs is revealing. Firstly, those who saw CDOs as the ticking time-bombs they were do not see CLOs as the next black swan. Mike Burry, the Scion capital investor credited with first identifying the sub-prime crisis, now points the finger at exchange traded funds (ETFs), saying that the rise of passive investing is at risk of causing a bubble.

Greg Lippmann, a former Deutsche Bank trader and another star of Michael Lewis’s The Big Short, which told the tale of the subprime crisis and who correctly identified the lapse lending standards in the subprime market, has even bought a CLO firm.

Steve Eisman, who also shorted US subprime, is the only one of the three from Lewis's account who has expressed concerns about the growing leveraged loan market. However, the hedge fund manager pointed to the rise of poorly rated debt, not at CLOs themselves. He also said he does not see corporate debt causing the next recession.

Indeed, it seems only those outside of the market making the comparison — such as the outgoing Bank of England governor Mark Carney — rather than those who have the most to lose if the market begins to teeter.

In with the new

That’s not to say there aren’t legitimate problems with the asset class, though. The best arguments are the ones which point out that modern CLOs are more-often-than-not issued without covenants, which would lead to lower rates of recovery than before. There are also a lot more of them — the size of the leveraged loan market has doubled since 2008.

But this is to ignore the facts about how the CLO market has performed over the past 20 years, especially in Europe. Any serious commentator must acknowledge that only 11 European CLOs from the crisis era ever defaulted.

Out of S&P’s ratings, only 21 pre-crisis CLO tranches went into default out of 1,442 — approximately 1.5% of the market. Not one of these tranches had a triple-A rating, or even a double-A or a single-A rating.

In the US, there were 40 tranche defaults, with only one of these reaching a double-A tranche. For comparison, the one-year average default rate for CLOs remains only 1%, compared with 13% for CDOs.

One common factor among the 11 CLOs which did see defaults was low credit enhancement for the triple-A tranche. This was usually between 28% and 30% before the crisis. Today, the average is around 50%. One European CLO manager said they couldn’t break the triple-A tranche of a CLO even if they got up in the morning and tried.

The securitization market has matured since 2008. Resecuritizations, along with arbitrage synthetic securitizations, are banned across the world along with CDOs themselves. The rating agencies are under much more scrutiny they once were and are often outspoken when they disagree over securitization ratings, something which never happened pre-crisis.

The leveraged loan market is bigger than before and has many issues, but CLO structures are not one of them. They are fundamentally more transparent and more robust than pre-crisis issuance, which survived the worst crisis in living memory with barely a few scratches. 

Once the credit cycle turns and CLOs hold firm, there will be no excuse for maligning an asset class which has proven its resilience.

By Tom Brown
19 Nov 2019