It’s funny to see the people who run financial markets so eagerly rushing into committing the same mistake. Rushing for what? The same old, usual story. The enticement of higher profits by undertaking higher risks provides the same high to these investors as drugs do to teens. The global financial markets, which had a near-death experience with CDOs just a decade ago, face a new product ready to facilitate its total obliteration.
The product in question this time is CLOs, or Collateralized Loan Obligations. Believed to be a safer version of the infamous CDOs, or Collateralized Debt Obligations, which was one of the main culprits of the 2008 Financial Crisis, CLOs are already raising eyebrows all around the world. With the Governor of The Bank of England Mark Carney and the former Fed Chairman Janet Yellen warning about the potential risks, governments and the public are becoming wary. However, it looks like these warnings are having no effect on banks and institutional investors, for whom it was intended, as they continue buying CLOs.
A CLO is very similar to a CDO which, as mentioned earlier, was the main reason for the downfall of the financial markets in 2008. A CLO is basically a huge collection of loans given out by a bank for sale to banks and institutional investors in small tranches or groups. The benefit that an investor gains from buying a CLO is that he gets to earn the entire interest from the loans in his group or “tranche”.
With the amount of CLOs currently outstanding in the world crossing $700 billion, and with $100 billion being added each year, the amount of CLOs has already reached the levels of CDOs before the Financial Crisis of 2008. The structuring of a CLO is the same as a CDO. The groups of CLOs are rated by rating agencies on the basis of the overall creditworthiness and mortgaged assets. The CLO groups are majorly rated into AA, BBB+, BBB- and so on. Within each individual group, each specific tranche is also rated. Hence, in an AA class group, there are tranches rated AA, BBB+, BBB- and so forth. The same goes for the BBB+ class group and all the other groups which follow. The highest tranche of the highest group is paid first, followed by all the tranches in the highest group, which is followed by all the groups and their respective tranches. Hence, the lowest class tranche of the lowest group is the riskiest, and promises the highest return, whereas, the highest class tranche of the highest group is the safest and promises least return. This allows investors to invest in groups and tranches according to their risk appetite.
The only way in which CLOs have differed from CDOs have been stricter banking regulations and the type of loans which are being put into the groups. Instead of having only housing loans, CLOs offer a wide variety of loans such as automobiles, housing, retail and so on. Moreover, stricter regulations demand that banks hold some proportion of each group of CLOs in order to ensure that to earn a riskless profit, the banks are not just giving loans to any individual they meet, which happened in the case of CDOs during the Financial Crisis of 2008.
Proponents of CLOs point towards the double-digit returns, low default rates and resilience to rising interest rates. With banks such as Credit Suisse, Nomura, Barclays and JP Morgan Chase showing confidence in CLOs due to its high returns and substantially low risks, the demand for CLOs is rising in international markets. The industry is stressing the fact that CLOs are not as vulnerable to rising interest rates as CDOs were a decade ago. They also stress the fact that only 36 tranches among the 1500 plus CLOs rated by S&P Global Ratings have defaulted since 1994.
However, there are downfalls. Investors assume that the portfolios are safer as they are better diversified. But, diversification of portfolios has led to them being made of fewer and larger loans, which increases concentration risk. These leveraged loans are highly sensitive to economic conditions, with many loans defaulting as soon as the economic conditions take a downturn. The condition will be particularly adverse for Japanese banks, which have bought 75% of AAA tranches and one-third of all CLOs, finance their operations by borrowing from international markets. Losses can lead to difficulties in continuing operations, which in turn may lead to a liquidity squeeze.
In the case of a downturn, the CLOs pose a risk of creating adverse feedback loops. Banks will be stuck with unsold loans clogging up inventories due to a decrease in demand. Falling prices and tightening credit availability will cause credit markets to seize up. Tighter credit will feed into the real economy triggering losses, selling and price declines. Fears about the financial positions of banks and investors will create havoc as depositors refuse to fund banks and investors demand their money back.
Hence, it is clear that governments need to set in motion regulations and a robust framework on how to go about dealing with CLOs. This is extremely necessary as everyone today is accepting the fact that CLOs are a potentially dangerous item capable of causing devastating chaos in the international markets. Still, banks and institutional investors are pouring money into this product with the hopes of higher returns from the higher risks they undertake. It is clear that CLOs have the capability to topple the global financial markets if it spirals out of control. Therefore, with the world talking of another financial crisis, the question that needs to be answered is will it be the phoenix of CDOs that proves to be the catalyst? The danger that currently beholds us is that if we keep allowing investment junkies to get their risk-fuelled fix, it will be the rest of us left to pick up the tab if the international financial system enters rehab.
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