Will secured loan obligations cause collateral damage?
In the heart of the global financial crisis from 2007-09 was an obscure credit derivative called the secured debt obligation (CDO). CDOs were debt-based financial products – most notoriously residential mortgages – that were sold by banks to other banks and institutional investors.
The profitability of these CDOs largely depended on the owners’ ability to repay their mortgages. When people started to default, the CDO market collapsed. And because CDOs were closely linked to other financial and insurance markets, their collapse bankrupted many banks and left others in need of government and central bank support.
Many thought this would end the complex structured credit derivatives market, but it is not. From 2021, a close cousin CDO known as the secured loan bond or CLO was approaching the equivalent market value of CDOs at its peak. A record number of CLOs have been published in august, and the market as a whole is nearly $ 1,000 billion (Â£ 726 billion) in value. Lots in the financial services industry say that there is nothing to worry about, but there are good reasons they could be wrong.
How CLOs differ from CDOs
Secured loan obligations are underpinned not by mortgages but by so-called leveraged loans. These are business loans from syndicates of banks that are contracted, for example, by private equity firms to pay for buyouts.
Supporters of CLOs argue that leveraged loans have a lower record defaults than subprime mortgages and CLOs have less complex structures than CDOs. They also argue that CLOs are better regulated, and have larger buffers against defects due to a more conservative product design.
None of this is wrong, but that doesn’t mean the risk is gone. Mortgages, for example, had low default rate in the 1990s and early 2000s. But as CDOs allowed banks to sell their mortgages in order to free up their balance sheets for more loans, they began to lend to riskier clients in their search for more money. ‘business.
This easing of lending standards in subprime mortgages – mortgages given to borrowers with bad credit – increased the potential default rate of CDOs, as people who could hardly pay their mortgages stopped paying. repay them. The danger is that the same appetite for CLO can the same reduce the standards of leveraged loans.
In one respect, CLOs can even be worse than CDOs. When homeowners failed to pay off their mortgages and banks took over and sold their homes, they could recover substantial amounts that could be passed on to CDO investors. However, businesses are quite different from homes – their assets are not just bricks and mortar, but also intangible things like brands and reputation, which can be worthless in a default situation. This can reduce the amount that can be recovered and transferred to CLO investors.
In a recent paper, we looked at the similarities between CDOs and CLOs, but rather than comparing their designs, we looked at legal documents that reveal the networks of professionals involved in this industry. Actors who work together over several years build trust and shared understandings, which can reduce costs. But the mundane sociology of repetitive trading can take on a dark side if companies make concessions or become too interdependent. This can lower standards, indicating another type of risk inherent in these products.
The United States-appointed Financial Crisis Commission of Inquiry (FCIC) found evidence of this dark side in its 2011 report in the collapse of the CDO market, highlighting the corrosive effects of repeated relationships between rating agencies, banks, mortgage providers, insurers and others. The FCIC concluded that complacency set in as the industry readily accepted increasingly substandard mortgages and other assets to put into CDOs.
Not surprisingly, creating CLOs requires many of the same skills as CDOs. Our article revealed that the key players in CDO networks in the early 2000s were often the same as those who developed CLOs after 2007-09. This raises the possibility that the same industry complacency may have set in again.
Indeed, the quality of leveraged loans has deteriorated. The proportion of US dollar denominated loans known as alliance-light or cov-lite – which means there is less protection against creditors – is passed from 17% in 2010 to 84% in 2020. And in Europe, the percentage of cov-lite loans is estimated at to be higher.
The proportion of US dollar loans to companies with more than six times the debt – meaning they were able to borrow more than six times their earnings before interest, taxes, depreciation, and amortization (EBITDA) – also increased by 14% in 2011 at 30% in 2018.
Before the pandemic, there were alarming signs of borrowers exploiting looser lending standards in leveraged loans to move assets into subsidiaries where the restrictions imposed by loan covenants would not apply. In the event of default, this limits the ability of creditors to seize these assets. In some cases, these unrestricted subsidiaries were able to borrow more money, meaning the entire company owed more in total. This has strong echoes of the financial creativity that led to riskier borrowing in 2005-07.
So how worried should we be? The CLO market is certainly very large, and corporate defaults could skyrocket if it turns out that the extra money pumped into the economy by central banks and governments in response to the COVID crisis does not. offers only a temporary stay. The big buyers of these derivatives again appear to be large systemically important banks. On the other handaccording to some accounts, these derivatives are less intertwined with other financial and insurance markets, which can reduce their systemic risks.
Nonetheless, the market is at least large enough to cause disruption, which could cause major upheaval in the global financial system. If the networks behind these products become risk-blind and allow CLO quality to slowly erode, don’t rule out the problems ahead.
Daniel Tischer, Senior Lecturer in Management, Bristol University; Adam leaving, Professor of Accounting & Society, University of Sheffield, and Jonathan Beaverstock, Professor of International Management, Bristol University
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