Are CLOs The Next CDOs?

We all know that the financial crisis was caused by risky mortgages and excessive leverage deployed by the banks. When the housing market crashed in 2007, the underlying mortgages collapsed in value, ruined the banks’ balance sheets and caused the economy to crater.

These risky mortgages were packaged and sliced up into tranches of collateralized debt obligations, or CDOs.

According to the investor website Investopedia, a CDO is a structured financial product that pools together cash flow generating assets, including mortgages, and repackages this asset pool into discrete slices, or tranches, that can be sold to investors.

A similar, risky leverage product being sliced up and peddled by Wall Street banks at the moment is collateralized loan obligations or CLOs. Will the boom in CLOs cause a financial crisis similar to the catastrophic explosion in mortgage lending and CDOs?

A CLO is a portfolio of typically low rated leveraged loans. Like CDOs, CLOs  are structured as a series of slices or tranches that are sold to investors.

The risks of CLOs sure sound similar to CDOs. What do the experts think?

One Wall Street Journal columnist recently highlighted the current risks and danger in the market for these securities, particularly as the Trump administration and a Congress controlled by Republicans move to deregulate Wall Street.

“It’s easy to lend money,” wrote James Mackintosh earlier this month in the Journal. “The trick to successful finance is getting it back—and lenders, egged on by politicians, are once again forgetting how hard it can be to recover debts in a downturn.”

“The Trump administration wants banks to be less regulated, and right at the front of the line are restrictions on the riskiest type of corporate loans, known as leveraged loans,” noted Mackintosh. “These are used to finance highly indebted private-equity deals or weak companies, and worried U.S. regulators put rules in place five years ago to try to stop banks from taking silly risks. Europe last year followed suit, but the U.S. rules are now being recast as merely guidance.”

“Looser rules on banks after a long market boom should ring alarm bells,” he added. “But while weaker credit standards mean bigger losses when loans turn sour, they will help magnify market gains as long as the economy stays sweet. Even better, more lending itself helps economic growth, right up until the excesses are exposed.”

He continued: “The excesses are becoming visible. Leveraged lending hit a new high of $1.6 trillion last year, spreads over the interbank lending rate neared post crisis lows and lenders showed an unprecedented willingness to waive the usual protections. Just as in the high-yield bond market, covenants designed to prevent the most egregious behavior of borrowers were scrapped and investors took more on faith: Half of U.S. leveraged loans and 60% of Europe’s are ‘covenant-lite,’ according to the Institute of International Finance, a trade group.”

“This is a market with a ton of cash chasing too few deals,” according to one major underwriter cited by the reporter. “It feels awfully frothy, going back to the days of 2006, 2007.”

Interest rates will rise this year, leading to increasing loan defaults by sketchy borrowers. One cannot help but think that the seeds of another financial crisis abound.

Investors should be worried about the CLO ticking time bomb. It clearly presents a similar danger as the CDO collapse caused in 2008.

Wall Street banks are at it again, and it looks like history is repeating itself. Market excesses often spells bad news for Mom and Pop investors.

Zamansky LLC is a New York law firm which represents investors in court and arbitration cases against securities brokerage firms and issuers.  The firm may represent investors in cases against companies mentioned in this blog.

Zamansky LLC also represents investors in arbitration cases against UBS and other brokerage firms regarding Puerto Rico bonds and UBS closed end bond funds and other investments.