Could secured loan obligations trigger the next financial crisis? – Citigroup Inc. (C), JP Morgan Chase & Co (JPM), Wells Fargo & Company (WFC)
One of the benefits of the 2020 economic downturn is that so far, unlike 2008, the global financial system does not appear to be in immediate danger. However, in her daily newsletter last week, Whitney Tilson said that something is threatening the stability of global banks in 2020 as well.
CDO Vs. CLO: During the financial crisis of 2008 and 2009, one of the greatest risks to the stability of the financial system was the collapse of collateralized bonds, or CDOs. Back then, these CDOs were built from collections of mortgage bonds. Although they received AAA credit ratings from rating agencies, many of these CDOs were built from low-quality subprime mortgages, which ultimately collapsed during the bursting of the housing bubble.
Tilson said a similar situation is occurring with Secured Loan Bonds, or CLOs. Instead of mortgage bonds, CLOs are built from business loans.
“The CLO market has exploded over the last decade… It’s a by-product of the private equity boom, which is racking up tons of debt on its acquisitions,” Tilson said.
Exposed banks: The prolonged period of low interest rates has caused banks to become more aggressive in their business lending strategies over the years.
“CLOs should work well for banks, unless – like mortgages in 2008 – all loans go bad at the same time,” Tilson wrote.
In 2018, the Bank for International Settlements estimated that $ 250 billion of the $ 750 billion global CLO market was on the balance sheets of major banks. UC Berkeley law professor Frank Partnoy says Wells Fargo & Co (NYSE: WFC) owns $ 37 billion of CLO, JPMorgan Chase & Co. (NYSE: JPM) owns $ 35 billion of CLO and Citigroup Inc (NYSE: C) owns $ 20 billion in CLO. Unfortunately, as investors learned in 2008, these bank balance sheets are notoriously unclear.
While banks are exposed to the CLO market, insurance companies are also exposed. In fact, the US insurance industry has about $ 158 billion in collective exposure to CLOs, according to Tilson.
Fitch recently estimated that about 82% of corporate debt supporting CLOs themselves is rated B or less.
The good news: Tilson said the good news for investors is that the AA-rated tranches of the CLO market still appear far from danger. There are two key distinctions between the CLO market today and the CDO market in 2008. First, many mortgage loans backed by the CDO market in 2008 were simply fraudulent.
“The loans were given to consumers on the basis of income and other data that was simply made up. There is no evidence that business loans have been consistently over-priced in the same way, ”Tilson said.
Additionally, Tilson said there should be a much lower correlation between corporate bonds backed in the CLO market today than there was among mortgages backed in the CDO market in today. 2008. Corporate bonds come from a wide range of different sectors and industries, which helps create greater diversification within the CLO market.
Benzinga’s point of view: One of the reasons why the SPDR S&P 500 ETF Trust (NYSE: SPY) has been so resilient throughout the severe economic downturn triggered by COVID-19 due to the massive debt the US government has taken on and the massive amount of debt US businesses have added to their balance sheets to fight the recession.
Concerns about the stability of the CLO market are just one of the questions raised by investors worried about the potential long-term fallout from such reliance on debt.
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