This post was originally published on this site
In April, Moody’s placed 20% of its rated collateralized loan obligations (CLO) (valued at around $22 billion) on review. The decision carried ominous echoes of 2008 and the Great Financial Crisis, when collateralized debt obligations (CDOs) proved problematic for the U.S. and global economies. In the current financial crisis, CLOs, which — despite industry protestations to the contrary — share many of same structural characteristics as CDOs, may cause similar problems.
Like mortgage securitizations, CLOs package portfolios of corporate loans (often of lower-quality) into investable securities. Investors do not take a pro-rata interest in the portfolio but instead take different slices of risks. In return for higher returns, investors in the equity or subordinated tranches take the first losses. Meanwhile, Investors in the senior tranches are protected against these first losses and receive lower returns. In recent years, the underlying assets used have been riskier non-investment grade leveraged loans.
The equity tranche investors are typically hedge funds, private equity, institutional investors (pension funds, insurance companies), some mutual funds (depending on their mandates) and high-net-worth individuals. Some emerging-market banks also purchase the equity tranche. Generally, they are looking for the high yield and hoping for either no defaults or just a few.
To enhance investor returns, CLOs have introduced higher levels of leverage and complex risk. While banks are required to hold capital of up to 16% against their loan exposure, CLOs, which are not regulated, hold significantly less. This increases leverage, generating potentially higher returns for shareholders.
Gains and (spectacular) losses
But CLOs expose investors to loss leverage, that is, they change sensitivity to particular events.
For example, assume a CLO based on a diversified $1 billion portfolio consisting of 100 loans of $10 million each. If any of the loans default, then you recover 40% of the amount lent from realizing the underlying assets, and you take a 60% loss. On each $10 million loan, lenders would lose $6 million (60% of the $10 million exposure) if the borrower defaulted.
If an investor invested $30 million pro rata in the 100 loans or US$300,000 per loan ($30 million divided by 100), then five defaults in the portfolio would result in a loss of US$0.9 million ($300,000 times 60% times 5).
Contrast this with the investor investing the $30 million in the equity tranche of a CLO based on the portfolio of 100 loans of $10 million each. Under the CLO arrangements, you are required to take the first losses until your entire investment is written off.
So, an investor must take the first few defaults in their entirety — not pro-rata as where they spread their money across all the loans. The investor is exposed to the first five defaults out of the 100 loans in the portfolio. Any five losses would wipe out the entire equity investment of $30 million ($6 million loss per loan times 5).
Even though the underlying loans are the same, the investor risk profiles are dramatically different. For the same event, with any five losses, the loss for the diversified investor is $0.9 million versus $30 million for the CLO equity investor. For the same five losses. the CLO equity investor will suffer a loss 33 times greater than where an investment is spread equally across all 100 companies in the portfolio. This is known as default- or loss leverage.
In effect, for investors in CLO securities the risk is not diversified. They are exposed to the first five loans to default in the portfolio. For investors in the safer, better-rated CLO tranches, the opposite holds true, as they are protected from these defaults. Yet they may be leveraged in a different way.
Layers of leverage
The structure creates exposure to the correlation between defaults. If there are few defaults, then most of the losses are absorbed by the riskier tranches, benefitting the investors in the safer securities whose investment remains unaffected. But if there are many defaults driven by something like the coronavirus pandemic, ironically, the investors in riskier securities are protected as their loss is capped by the amount of their investment; e.g. the $30 million above. Investors in the senior, and safer, securities assume greater exposure to systemic events.
More: Why ‘the next big shoe to drop’ in the U.S. economy could hit by July
The complexities of loss leverage are poorly understood. Many investors rely on the ratings of the CLO securities and rating agency risk models, which are highly sensitive to assumptions.
Purchasers of higher-rated tranches can leverage their holding by borrowing or financing purchases of securitized debt by entering into repo agreements or total returns swaps. In the case of AAA-rated CLO securities, leverage of up to 10 times may be available. These borrowings expose the investors to the risk of margin calls where the underlying CLO security is downgraded or its value declines.
CLOs create layers of leverage within the financial system. The underlying loans are frequently issued by highly indebted companies, often private equity transactions. CLOs, which are major purchasers of these loans, are themselves leveraged. Investors in CLO securities may also borrow against their holdings usually from financial institutions who are also leveraged.
The multiplication of leverage transmits and amplifies risk within the financial system. If defaults or downgrades occur, then a destructive sequence of deleveraging ensues.
CLOs highlight deep-seated shortcomings in financial engineering and investment practices. Addressing these problems requires policy makers to deal with a global economic model that is dependent on debt. But this is something they continue to refuse to do.
Satyajit Das is a former banker. His latest book is A Banquet of Consequences (published in North America as The Age of Stagnation). He is also the author of Extreme Money and Traders, Guns & Money.
Read: Why dividend income will evaporate in the post-coronavirus market
More: Too many investors are failing to grasp that the coronavirus recession may be longer and tougher
