FROM EIR DAILY ALERT

‘CLO Debate’ Reflects Connection of Economic Downturn and Crash

March 4, 2019 (EIRNS)—In December former Federal Reserve Chair Janet Yellen, speaking in New York, joined other regulators in warning that $4 trillion in leveraged corporate loans and junk bonds could blow up into another “2008” financial crash. Yellen also said that the heavy use of this “junk debt” to create derivatives products, known as collateralized loan obligations (CLOs), being purchased by banks and “shadow banks” like hedge funds, added to the danger—this is what triggered the 2008 crash, she said. When would this happen? When a new recession forced corporate bankruptcies and defaults; this from Yellen who, in her last months as Fed chair in 2017, had said we would not see another financial crash in our lifetimes.

Since then, JPMorgan Chase and Goldman Sachs have published big reports claiming that CLOs are not dangerous—that was only collateralized debt obligations (CDOs). Of course, CLOs are a subset of CDOs!

On March 2 Bloomberg ran “The Bomb that Blew Up in 2008? We’re Planting Another One,” by former banker and now well-known economics author Satyajit Das. His subject was CLOs. Das explained they are derivative products like CDOs, but each CLO is based on small numbers of large corporate leveraged loans, instead of large numbers of small mortgages. There are $700 billion in such securitized leveraged loans now, and hedge funds, mutual and pension funds, and Japanese banks have been buying $100 billion more a year. This makes them more risky and dangerous.

One shale oil driller, one Sears, even one GE going into default, can cause major losses from such a derivative product. Many over-indebted firms doing so—i.e., a recession—could trigger a financial blowout, as Yellen had already warned. And recession is what we now see hitting across Europe, while the recent U.S. economic growth is suddenly dropping toward zero.

“Several aspects of this risk aren’t well understood,” Das wrote.

“The credit quality of the leveraged loans which underlie the bulk of CLOs is poor, typically not investment-grade. Borrowers are highly leveraged. The loans increasingly have minimal investor protection, with over 70% lacking any covenants that would allow monitoring of financial condition and early intervention to manage problem borrowers.”

He concludes,

“There are too many parallels to 2008 for comfort. Investors, many with uncertain expertise and weak holding power, have increased their exposure in the search for higher returns, which can be as high as 20% for the riskiest equity pieces.... Built into this speculative episode, like its predecessors, is a euphoric flight from reality and a blindness to risks that continue to rise.”