Lately, investors have become nervous that a type of debt instrument on many banks’ balance sheets—a collateralized loan obligation, or CLO—could lead to another banking crisis. A compared CLOs to the collateralized debt obligation (CDO) market that was at the heart of the financial crisis in 2008-2009.
While we see plenty of risks in the loan market, we don’t believe the CLO market is putting the banking system at risk. Here’s some background on these instruments, and why we think the current situation is different from 2008-2009.
What are CLOs and CDOs?
CLOs are bundles of business loans, usually below investment grade, and therefore risky. A manager will typically buy and sell loans within the CLO structure and sell stakes in the CLO to investors. The appeal of the structure is the diversification across industries, very short duration and professional management.
One key feature of CLOs is that they are segmented into groups called tranches—usually a handful of debt tranches and then an equity tranche. The debt tranches carry credit ratings, and the top tranche is usually rated “AAA.” This tranche usually offers the lowest yield in exchange for the highest claim to the underlying assets and cash flows. The AAA rated tranche is generally the last to suffer a loss or be impaired if the underlying loans default. Meanwhile, the lowest tranche is usually the “equity tranche,” which is unrated and is the first to absorb losses if the underlying loans default. Unlike the debt tranches that make coupon payments, the equity tranche usually does not make scheduled payments, but has a claim to any excess cash that is not distributed to the tranches above it. According to S&P, no AAA rated U.S. CLOs have ever defaulted.1
Although a CLO sounds a lot like a CDO, there are significant differences, including:
- Many of the CDOs that caused so much damage in the financial crisis were structures backed by home mortgages and therefore had exposure to just one industry—the housing market. These were often bundles of the lowest-rated mortgages, referred to as sub-prime. As we now know, the mortgage market was plagued by lax regulation, and at times outright fraud. Because lending standards were very loose during the era that led up to the financial crisis, the level of actual defaults far exceeded what historical experience would have suggested. Consequently, models used to estimate default rates and determine credit ratings were often unreliable.
- Credit default swaps played a role in the crisis, as well. Credit default swaps are contracts that insure against losses on the lower-rated, riskiest tranches. These securities allowed an investor to profit if there was a rise in defaults, while the holders of the mortgage-backed securities could see a total loss of capital. It was the banks that often incurred these losses. Investors used leverage to buy CDOs on the assumption that the insurance would cover their losses. When it was clear that the companies that offered these default swaps would not be able to pay, the financial system came under extreme pressure and needed rescuing.
In addition to these differences in structure and underlying securities, there are four reasons why we don’t believe the CLO market will cause widespread damage to the banking system:
- CLOs are less complex than CDOs. Before the financial crisis, CDOs generally used many derivatives, like credit default swaps, and re-securitizations, meaning CDOs were packaged into even more CDOs, sometimes called a CDO squared. These structures increased the leverage so that even a low level of defaults could mean the whole structure collapsed. CLOs are simply composed of underlying loans, with different tranches taking on varying levels of risk.
- Bank exposure is much lower. The Atlantic article stated that Wells Fargo’s exposure to CLOs was nearly $30 billion. While that seems like a lot in an absolute sense, it’s just 1.5% of the bank’s total assets. Looking at relative numbers is important. More importantly, banks generally hold the AAA rated tranches, which historically have not lost principal.
- The banking sector is much better capitalized now. Tighter financial regulations following the global financial crisis have led to much stronger balance sheets. The capital ratios of most large U.S. financial institutions remain well above the pre-global financial crisis highs.
- The default outlook is not as gloomy as the article projects. This is still a risk, however. High-yield bond and loan defaults are piling up at the fastest pace since the global financial crisis, and Moody’s and S&P both expect the trailing 12-month speculative-grade default rate to peak above 12%. That’s very high, but in line with other recessionary norms and not as troubling as the dire projections in the article.2
The default rate is expected to rise to 12% by the end of the year, but AAA rated CLO tranches would likely be unaffected
Source: Moody’s Investors Services using monthly data as of May 2020. The cumulative default rate calculation methodology used by Moody’s is a discrete-time approximation of the nonparametric continuous-time hazard rate approach. A pool of issuers, called a cohort, is formed on the basis of the rating held on a given calendar date (or set of dates), and the default/survival status of the members of the cohort is tracked over some stated time horizon, which in this instance is 12 months. Default rates only include bonds rated by Moody’s.
According to Moody’s, the default rate peaked at just under 15% in 2009, but no AAA rated CLO tranches defaulted. If defaults were to rise above 10%, we believe it’s unlikely that any AAA rated CLOs—the tranche that banks tend to hold—would default.
Additionally, since CLOs are generally composed of corporate loans (and not derivatives), losses due to loan defaults won’t necessarily be magnified due to leverage.
What to do now
We don’t believe that CLOs will lead to another banking crisis. Yes, they are composed of risky loans, some of which are likely to default over the next 12 months, but this is a risk we’ve been highlighting for a while in our guidance for high-yield bond and bank loan investors. This is a risk for investors holding low-rated corporate bonds and loans, or funds that hold them.
However, given the less-complex nature of CLOs relative to CDOs (especially the lack of derivatives), the relative strength of bank balance sheets, and that banks generally hold the highest-rated tranches on their balance sheets, we don’t believe this poses an outsized risk to banks or the overall financial system.
1 Standard & Poor’s, “2018 Annual Global Leveraged Loan CLO Default and Rating Transition Study,” June 19, 2019.
2 Moody’s Investors Services, “Default Trends—Global, May 2020 Default Report,” June 10, 2020 and Standard and Poor’s, “The U.S. Speculative-Grade Corporate Default Rate Is Likely to Reach 12.5% By March 2021,” May 28, 2020.