- Daniel Tischer, Lecturer in Management, University of Bristol, Adam Leaver, Professor of Accounting and Society, University of Sheffield, and Jonathan Beaverstock, Professor of International Management, University of Bristol*.
At the heart of the global financial crisis of 2007-09 was an obscure credit derivative called Collateralised Debt Obligation (CDO). CDOs were financial products based on debt-most famously residential mortgages-sold by banks to other banks and institutional investors.
The profitability of these CDOs depended largely on the ability of homeowners to repay their mortgages. When people defaulted, the CDO market collapsed. And because CDOs were intertwined with other financial and insurance markets, their collapse bankrupted many banks and left others in need of government and central bank support.
Many thought this would put an end to the market for complexly structured credit derivatives, but did not. As of 2021, a close cousin of the CDO known as the Collateralized Loan Obligation, or CLO, was approaching the equivalent of the CDO market at its peak. In August, a record number of CLOs was issued, and the overall market is approaching the value of USD 1trn. Many in the financial services industry say there’s nothing to worry about, but there are good reasons why you might be wrong.
How CLOs differ from CDOs
Secured loan obligations are not supported by mortgages, but by so-called leveraged loans. These are corporate loans from banking syndicates, which are taken, for example, by private equity firms to pay for acquisitions.
Proponents of CLOs argue that leveraged loans have a lower number of defaults than subprime mortgages and that CLOs have less complex structures than CDOs. They also argue that CLOs are better regulated and carry more weighty buffers against failure through a more conservative product design.
Leveraged Loans: the new derivative base par excellence. Eames:
None of this is untrue, but that doesn’t mean the risk has disappeared. Mortgages, for example, had a low default rate in the 1990s and early 2000s. But since CDOs allowed banks to sell their mortgages to free up their balance sheets for more loans, they began lending to riskier customers in search of more business.
This loosening of lending standards in subprime mortgages-mortgages issued to borrowers with poor credit ratings-increased the default rate of CDOs as people who could no longer afford their mortgages stopped repaying them. The danger is that the same appetite for CLOs could similarly lower standards for leveraged lending.
In one respect, CLOs can even be worse than CDOs. If homeowners could not repay their mortgages and banks repossessed and sold their homes, they could recover significant amounts that could be passed on to CDO investors. However, companies are very different from houses – their assets are not only bricks and mortar, but also intangible things, such as brands and reputation, which can be worthless in a standard situation. This can reduce the amount that can be collected and passed on to CLO investors.
In a recent article, we examined the similarities between CDOs and CLOs, but instead of comparing their design, we examined legal documents that reveal the networks of professionals in this industry. Actors working together over several years build trust and common understanding, which can reduce costs. But the secular sociology of information exchange can have a dark side when companies make concessions to each other or become too dependent on each other. This can lower standards and indicate a different type of risk inherent in these products.
The US-appointed Financial Crisis Inquiry Commission (FCIC) found evidence of this dark side in its 2011 report on the collapse of the CDO market, highlighting the corrosive effects of repeated relationships between credit rating agencies, banks, mortgage providers, insurers and others. The FCIC concluded that complacency set in when the industry willingly accepted mortgages and other assets of increasingly inferior quality to put into CDOs.
Not surprisingly, creating CLOs requires many of the same skills as CDOs. Our work found that the key players in the CDO networks in the early 2000s were often the same ones who developed CLOs after 2007-09. This raises the possibility that the same complacency of the industry may have set in again.
Sure enough, the quality of leveraged loans has deteriorated. The share of U.S. Dollar-denominated loans called covenant-light or cov-lite – meaning there is less creditor protection-increased from 17% in 2010 to 84% in 2020. And in Europe, the percentage of Cov-Lite loans is believed to be higher.
The share of US dollar loans to companies that are more than six times in debt-that is, they were able to borrow more than six times their earnings before interest, taxes, depreciation and amortization (EBITDA) – also increased from 14% in 2011 to 30% in 2018.
Before the pandemic, there were alarming signs that leveraged loan borrowers were taking advantage of looser credit standards to move assets to subsidiaries where the restrictions imposed by loan agreements would not apply. In the event of a default, this limits the ability of creditors to seize these assets. In some cases, these unlimited subsidiaries were able to borrow more money, which means that the company as a whole had more debt. This is strongly reminiscent of the financial crisis that led to riskier borrowing in 2005-07.
Has the network behind CLOs become too cozy? Aelitta
How worried should we be? The CLO market is certainly very large, and corporate defaults could rise if it turns out that the extra money that central banks and governments have pumped into the economy in response to the COVID crisis is only a temporary pardon. In turn, the main buyers of these derivatives appear to be large, systemically important banks. On the other hand, according to some reports, these derivatives are less interwoven with other financial and insurance markets, which can reduce their systemic risks.
Yet the market is at least large enough to cause some disruption that could lead to major unrest within the global financial system. If the networks behind these products become blind to the risks and CLO quality can slowly erode, they do not rule out problems.