CLO: The New CDO

The collateralized loan obligation, or CLO, is now in vogue within the world of finance. A CLO is a security that consists of loans with similar characteristics. These characteristics can be the dates on which the loans mature, their risk profiles, etc. The CLO have become popular due to the search among asset managers to generate high returns for their investors. The hunt for yield leading to crisis is a recurring theme in the banking sector. Bankers have an obligation to achieve returns for their investors. Moreover, if they outpace their benchmarks, they are rewarded with high fees, carried interest, and other compensation schemes. Unfortunately, we too often see bankers’ financial incentives take priority over the best interests of their investors. Hopefully this story doesn’t have the same ending as the last one.

During the 2008 financial crisis, bankers had packaged up subprime mortgages into tranches (securities) and sold them to investors. These securities were called collateralized debt obligations, or CDOs. Mortgages were placed into “senior” and “junior” tranches,” which differed in their interest rates and risk profiles. Junior tranches are the last to receive payback from the collateral in the event of default. This makes them riskier, but also higher yield. While junior tranches are understood to be risky, improperly rated senior tranches led to the financial crisis. Ratings agencies like Moody’s, S&P, and Fitch were negligent in their assessment of CDO risk. They assigned A ratings to senior tranches consisting of subprime mortgages that would ultimately go bust. A so-called “safe investment” wasn’t safe at all.

Misunderstood Risk

In a previous post, I had walked through the various risks associated with direct lending. Alternative asset managers are aggressively lending to small and medium businesses. These loans have floating interest rates, so if the federal reserve raises rates, small and medium businesses will owe their lenders higher interest payments. Small and medium businesses nevertheless accept capital from alternative asset managers and live with the risk of increasing interest rates. The direct lending business is booming, which makes competition for deals among alternative asset managers fierce. Alternative asset managers are therefore removing investor protections, or covenants, from their deals. These “cov-lite” loans can prevent investors from recovering large percentages of their investments.

If the underlying loans that comprise CLOs are risky, then we have reason to worry about the growing popularity of CLOs. Small and medium businesses have become addicted to debt. Rather than exercising caution in lending to these businesses, alternative asset managers have capitalized on the opportunity to provide more capital. The secondary market created by CLOs extends the risk associated with cov-lite loans to a larger pool of investors. One regulatory is growing concerned about the risk CLOs pose: Japan’s Financial Services Agency.

Regularity Scrutiny from Japan

Japanese banks hold billions of dollars of CLOs because they offer higher yields than domestic Japanese securities. Japan’s Financial Services Agency (FSA), however, believes the quality of the underlying loans is declining. The FSA has questioned both Japan Post Bank Co. and Mitsubishi UFJ about their risk management practices. The increased scrutiny is promising in that it’s a proactive measure. That said, simply identifying risks does not make those risks disappear altogether.

When I was younger, I hated going to my history classes. I asked my teacher why we study history in the first place. He responded, “we study history, so we don’t repeat our mistakes.” Those in the financial sector need to become better students of history. We’ve identified the causes of the 2008 financial crisis. We saw how badly it hurt our economy. Yet here we are, repeating past mistakes. Now that we know the threat CLOs pose, we need to be proactive in protecting ourselves.

What do you think about CLOs? Leave a comment below or contact me directly.