Collateralized Loan Obligations : Macroeconomic Impacts of Collateralized Loan Obligations
Collateralized Loan Obligations : Macroeconomic Impacts of Collateralized Loan Obligations. After the decline in popularity of collateralized debt obligations1, or CDOs, a new form of securitization came to light: collateralized loan obligations, or CLOs. Furthermore, CLOs have taken the world by storm; what began as a primarily European securitization method has now become popular across the world. CLO issuance is on the rise at an alarming rate. The previous record for CLO issuance in a year was set in 2014 with $124.1 billion dollars2.
While this number is not as high as the CDO issuance in the years leading up to the financial crisis of 2007, as the CDO issuance in just the first quarter of 2007 was $145 billion4, CLOs have become relevant when talking about the macroeconomic stability of the world. This rise in popularity raises the question: “Do CLOs have the same destructive powers as CDOs and can they cause another credit crisis similar to the one in 2007?”
This is an important question to be asking because over-leveraging of major funds was one of the major factors that caused the financial crisis of 2007. Moreover, in this paper, I will be discussing the different risks of the use of CLOs and why I conclude that CLOs are unlikely to cause a financial crisis similar to the one in 2007 in the impending future.
Collateralized loan obligations are a method of securitization. Securitization is the process in which individual loans are pooled together into a larger financial structure and cut up into “tranches,” which are then sold to investors5. A tranche is a fractional interest in the larger financial structure which accrues interest from the loans it contains6.
Moreover, 2018 CLO issuance to be $150 billion, shattering the previous record by over $25 billion3.
1 There was a decline in collateralized debt obligations in the years after 2007 because they were the financial instruments that allowed the levels of leverage that caused the Financial Crisis of 2007.
2 Sarah Husband. “US CLO Issuance Hits Record $124.1B in 2014.” Leveraged Loan. Jan. 7, 2015. 3 Haunss, Kristen. “US CLO market on pace for a record year.” Reuters. July 10, 2018.
4 “CDO Issuance, by Primary Collateral Type.” Asset-Backed Alert: CLOs/CDOs, 31 Mar. 2007. 5 “What Is Securitization?” The Motley Fool, The Motley Fool, 17 July 2016.
6 Amadeo, Kimberly. “Tranches Created Both the Housing Boom and Financial Crisis.” The Balance Small Business, The Balance, 9 May 2018.
Securitization is a very important procedure in finance. It is what allows for banks to offer loans and lines of credit. Without securitization, banks would be exposed to increases in interest rates set by the government, as they would have no hedge against the interest payments that they give to people who deposit money into their bank7.
If the banks were exposed to this large of a risk, they would have no incentive to offer loans to people, and this would result in people not being able to get loans to pay for their expenses. In the case of the housing market, people would not be able to afford to buy a house outright with cash, so there would be a decreased demand for housing, resulting in a crash in housing prices, much like the financial crisis of 2007.
A collateralized loan obligation is much like the mortgage-backed CDOs of the early 2000s. The creation of a CLO starts with a CLO manager going to investors and asking for money to buy different loans from banks. The CLO manager then combines the loans into a larger financial structure and splits the structure into different tranches, which the CLO manager then gives to the investors that originally backed the purchase of the loans. Each tranche has different ratings based on the amount of risk that they are exposed to.
The tranche that is paid first has the highest rating, but it gives the investors the smallest return. The tranche that is paid last has the lowest rating, meaning that it is the riskiest, but it gives the highest return. All of these tranches are paid before a sub-structure called the equity layer, which is below the lowest rated tranche, typically BB. In addition, if any of the loans were to default, the equity layers would be the first to have their payments rescinded, followed by the BB-rated loans (the riskier loans) and it would reverberate up the CLO up to the AAA-rated loans (the safest loans)8.
7 Conerly, Bill. “Why Borrowers Need Securitization.” Forbes, Forbes Magazine, 5 June 2018. 8 “Understanding Collateralized Loan Obligations (CLOs).” Asset-Backed Securities (ABS) | Guggenheim Investments, 5 Apr. 2017.
While CLOs and CDOs have very similar financial structures, there is one key difference that plays a large part in the exposure that the economy has to these structures: the CDOs that caused the financial crisis of 2007 used mortgage bonds as the loans in the CDO structure, while in the case of CLOs, corporate loans are used6. Corporate loans are loans issued by banks to companies for the company to use at its discretion.
For example, if a chain of restaurants wants to expand into a different region, they would seek a corporate loan to fund the expansion.
This plays a big role in determining the risk of using CLOs, which is a topic that is discussed later in this paper. Other than the choice of debt that is used in the financial structure, there is only one major distinction between CDOs and CLOs: the quality of debt. In addition, CLOs have a much higher standard that they hold the debt to, perhaps learning from their mistakes in 2007. Furthermore, CLO managers purchase “a diverse pool of senior secured bank loans9,” which means that they purchase from the set of bank loans that are guaranteed to get paid first in the case of a default, mitigating the risk.
One thing to note about CLOs is that they are not mark-to-market instruments. Mark-to market means that they derive their price from the current market value of the asset10. Because the price of the asset is not being currently updated, they “have extremely high hurdles to meet before collateral liquidation is triggered, making them better equipped to withstand market volatility”.11
After the financial crisis of 2007, there was an increase in the regulation of financial markets. One sector that was impacted heavily was the financial services sector. More specifically, securitization was impacted. After all, an under-the-radar risk shift occurred with
9 “Understanding Collateralized Loan Obligations (CLOs).” Asset-Backed Securities (ABS) | Guggenheim Investments, 5 Apr. 2017.
10 Kenton, Will. “Mark To Market – MTM.” Investopedia. December 13, 2018.
11 “Understanding Collateralized Loan Obligations (CLOs).” Asset-Backed Securities (ABS) | Guggenheim Investments, 5 Apr. 2017.
the use of CDOs in the years leading up to 2007. In his paper, Hacker describes the risk shift of health insurance, but his logic can be applied to CDO usage as well. Many Americans felt as if the financial services companies told them “you are on your own12.” The public was forced to bear the burden, even while playing no role in the crisis they were taking out mortgages under the advice of realtors who knew that they would be able to sell the mortgages to the large investment banks to be securitized at little to no risk to themselves.
Another reason for increasing regulation on CLOs was because they played a large part in the downfall of the economy. They allowed for the banks (like Morgan Stanley) and insurance companies (like American International Group) to over leverage their positions on the housing market, and when the loans in the mortgage bonds started to default, whole CDOs started to default, leading to the bankruptcy of these large corporations. And yet again, the burden of the bankruptcy was shifted onto the government and by extension, the taxpayers of the US.
One of the most prominent pieces of legislation that was passed as a result of the financial crisis of 2007 was the Dodd-Frank Wall Street Reform and Consumer Protection Act, or Dodd-Frank Act for short. The Dodd-Frank Act was created to manage the systemic risk that each individual firm had an overall market. In addition it set up a committee called the Financial Stability Oversight Council to identify risks to US financial stability that results from the activities of interconnected banks and to promote market discipline. Furthermore, the Financial Stability Oversight Council deems bank holding companies with $50 billion or more “systematically important.” This means that they are under greater scrutiny from the Financial Stability Oversight Council.
12 Hacker, Jacob S. The Great Risk Shift : the Assault on American Jobs, Families, Health Care, and Retirement and How You Can Fight Back
The Dodd-Frank Act requires that the debt-to-equity ratio of bank holding companies to be no greater than 15:113. It also requires that securitization managers retain a portion of the risk associated with the securitizations that they offer7. This retained risk is usually in the form of the equity of the securitization.
This part of the rule is very important because of the structure of the securitizations. Equity is lesser than debt in the case of defaulting, so equity would get paid after the tranches get paid, which means that if securitization managers put risky loans into the securitizations, then in the case of default, they would be the first ones to feel the effects, as they are on the bottom-most layer in the “pyramid of the securitization.” The final key tenant of the Dodd-Frank Act is called the Volcker Rule. The Volcker Rule states that banks are not allowed to use consumer deposits for the use of owning, investing in, or sponsoring hedge funds, which are investment funds that are known to have a high risk14.
While the Dodd-Frank Act was passed in 2010, CLOs became exempt from this law in early 201815. This is an alarming piece of legislation, as this puts CLOs in the same spot that CDOs were in the years leading up to the financial crisis of 2007. There are currently no major regulations that CDOs and CLOs are subject to. This is a systemic risk in and of itself because these securitizations allow for over-leveraging of positions, which could lead to widespread economic failure.
CLOs present risk, as any other leveraged financial instrument, but I do not think that they present that large of a systemic risk that could impact the general public. They present risk to corporations that are looking to expand. This is due to the nature of the debt that they include in the financial structure. They use corporate loans, not mortgage bonds. Corporate loans have a
13 Guynn, Randall D., and Davis Polk & Wardwell LLP. “The Financial Panic of 2008 and Financial Regulatory Reform.” Grading Global Boards of Directors on Cybersecurity, 20 Nov. 2010.
14 “The Volcker Rule.” CFA Institute
15 Spanheimer, Nathan. “D.C. Court Of Appeals Decides To Exempt CLOs From Dodd-Frank Risk Retention Rules.(collateralized Loan Obligations ).” Mondaq Business Briefing. Mondaq Ltd., February 13, 2018.
default rate of 4.1%16 while mortgages have a delinquency rate of 11.1%17, meaning that they are a much safer class of debt than mortgages. Also, the reason that the “everyday man” was affected by the credit crisis in 2007 was due to the fact that the housing market was the focus of CDOs. This is not the case for CLOs. Instead, the focus is companies that are growing. In addition, AT&T, in the past few years, has incurred a large amount of debt, the largest of which was to acquire Time Warner Inc.18
Moreover, this raises the question of whether or not AT&T can pay its debtors back. I believe that AT&T will be able to pay its debtors back because it has many cash flows that each generate a large amount of money, and the recent acquisition of Time Warner Inc. increases its cash flows19. Moreover, in the worst-case scenario, which would be that the corporate loans default, the growing companies would only have to declare bankruptcy of the divisions created by the expansion. The rest of the business would not have to default as well.
Collateralized Loan Obligations : Macroeconomic Impacts of Collateralized Loan Obligations
Another reason that I believe CLOs are relatively safe in their current state is due to the timing of the financial crisis of 2007. The financial crisis was especially destructive to the world’s economy because it coincided with the “long-term debt cycle” depression period20. In addition, the long-term debt cycle, a term coined by Ray Dalio, the Chief Investment Officer of Bridgewater Capital (a fund that was unaffected by the financial crisis of 2007), is a natural byproduct of human nature, the central bank controlling interest rates, and the central bank printing money. Moreover, it describes the cyclical nature of the leveraging and deleveraging of debt in the economy. This cycle dictates that there is a 65-90 year period of economic prosperity fueled by
16 Emery, Kenneth M., and Richard Cantor. “Relative Default Rates on Corporate Loans and Bonds.” Journal of Banking and Finance 29, no. 6 (June 2005): 1575-584.
17 “CoreLogic Insights Blog.” CoreLogic – Property Data Leader. June 12, 2018.
18 Shannon, Joel. “AT&T Says It Has Completed Its $85 Billion Acquisition of Time Warner.” USA Today. June 15, 2018.
19 AT&T Inc., Form 10-Q for the Period Ending September 30, 2018 (filed November 2, 2018). SEC EDGAR website. 20 Dalio, Ray. “How the Economic Machine Works.” Economic Principles, 2017.
leveraging followed by a 10 year period of economic depression fueled by deleveraging. Figure 1. This chart shows the cyclical nature of the two debt cycles described by Ray Dalio21.
The financial crisis of 2007 took place 78 years after 1929, which was the start of the Great Depression. This is around the time in the long-term debt cycle that is economic depression, as if confirmed by Figure 1. This is not to say that CDOs did not affect the outcome of the economy – they allowed for the ridiculous levels of leverage as a result of the Commodity Futures Modernization Act of 2000, which thwarted efforts to regulate financial derivatives, much like CDOs and CLOs.22.
And when it came time to deleverage, there was a wave of bankruptcy caused by CDOs that used other CDOs as their mortgage bonds (a way to leverage even more than a regular CDO), coined CDO-squared. Because there was an over leveraged before the depression began, there had to be an over deleverage. This over deleverage caused the crash of the housing market and mass unemployment. The depression was not caused by the securitization of assets but rather amplified to an extreme by it.
While I believe that CLOs do not present that large of a systemic macroeconomic risk, there are two red flags that if resolved, would minimize the risk. Moreover, the first is to allow the Dodd Frank Act to apply to CLOs again. The Dodd-Frank Act does not restrict CLOs from making
21 “Debt and the Financial Cycle: Domestic and Global.” The Bank for International Settlements. June 29, 2014. 22 “Cfma.pdf.” September 30, 2004.
money, as they were profitable in the years before the exemption from the act. Instead, the reapplication of this Act to CLOs decreases the likelihood for CLO managers to package riskier bonds and pass them off to investors as a good investment. In addition, the second red flag to resolve is to maintain the integrity of rating agencies. In the years leading up to 2007, rating agencies such as Moody’s and Standard and Poor’s were fraudulent in their ratings; they were giving AAA ratings to BB bonds. In fact, rating agencies wouldn’t warn CDO managers if their financial instruments became too risky.23 In addition, this presents a large amount of risk that can be passed off to the investors of the CDOs.
CLOs are a step in the right direction from CDOs. Both are methods of securitization, but CLOs are a much safer method. They use a safer type of debt in the financial structure. Also, CLO managers have a higher standard for the riskiness of debt that they put into their CLOs.
Finally, CLOs are not mark-to-market instruments. Which means that they are well suited to mitigate market volatility. In conclusion, with that being said, CLOs are essentially methods of securitization, which is a method of leverage. In addition, this means that under specific conditions, much like the ones found in 2007, they pose systemic risk. There are two things that need to be done before the risk of CLOs can truly be minimized: (1) the reapplication of the Dodd-Frank Act, and by extension the Volcker Rule, to CLOs and (2) the maintenance of the integrity of rating agencies. Lastly, if these two things are done, I do not think that CLOs will be as large of a factor in macroeconomic crises like the one in 2007 as CDOs were.
23 Lewis, Michael. “The End of the Financial World as We Know It.” The New York Times. January 03, 2009.
Collateralized Loan Obligations : Macroeconomic Impacts of Collateralized Loan Obligations
Amadeo, Kimberly. www.thebalance.com/tranches definition-risks-and-how-they-work-3305901.
AT&T Inc., Form 10-Q for the Period Ending September 30, 2018. Filed November 2, 2018. SEC EDGAR website.https://www.sec.gov/Archives/edgar-
“CDO Issuance, by Primary Collateral Type.” Asset-Backed Alert :: CLOs/CDOs, 31 Mar. 2007, www.abalert.com/rankings.pl?Q=96.
“Cfma.pdf.” September 30, 2004. https://www.sec.gov/about/laws/cfma.pdf. Conerly, Bill. “Why Borrowers Need Securitization.” Forbes, Forbes Magazine, 5 June 2018, www.forbes.com/sites/billconerly/2018/06/05/why-borrowers-need
“CoreLogic Insights Blog.” CoreLogic – Property Data Leader. June 12, 2018.
Dalio, Ray. “How the Economic Machine Works.” Economic Principles, 2017, www.economicprinciples.org/wp
“Debt and the Financial Cycle: Domestic and Global.” The Bank for International Settlements. June 29, 2014. Accessed December 14, 2018.
Emery, Kenneth M., and Richard Cantor. “Relative Default Rates on Corporate Loans and Bonds.” Journal of Banking and Finance 29, no. 6 (June 2005): 1575-584. Guynn, Randall D., and Davis Polk & Wardwell LLP. “The Financial Panic of 2008 and Financial Regulatory Reform.” Grading Global Boards of Directors on Cybersecurity, 20 Nov. 2010, corpgov.law.harvard.edu/2010/11/20/the-financial-panic-of-2008-and financial-regulatory-reform/.
Kenton, Will. “Mark To Market – MTM.” Investopedia. December 13, 2018. Accessed December 14, 2018. https://www.investopedia.com/terms/m/marktomarket.asp. Lewis, Michael. “The End of the Financial World as We Know It.” The New York Times. January 03, 2009. Accessed December 14, 2018.
Shannon, Joel. “AT&T Says It Has Completed Its $85 Billion Acquisition of Time Warner.” USA Today. June 15, 2018. Accessed December 14, 2018.
Spanheimer, Nathan. “D.C. Court Of Appeals Decides To Exempt CLOs From Dodd-Frank Risk Retention Rules.(collateralized Loan Obligations ).” Mondaq Business Briefing. Mondaq Ltd., February 13, 2018.
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“Understanding Collateralized Loan Obligations (CLOs).” Asset-Backed Securities (ABS) | Guggenheim Investments, 5 Apr. 2017,
“The Volcker Rule.” CFA Institute, www.cfainstitute.org/en/advocacy/issues/volcker-rule.