CLOs and the Crisis of the Markets

What are CLOs

Some investors fear that Collateralized Loan Obligations have begun to mirror the Collateralized Debt Obligations that were held responsible for the 2008 crisis. However, while both are composed of toxic loans that borrowers are likely to default on that have been dubbed AAA grade simply because they are “sufficiently diversified,” the market risk for these loans does not lie with banks. There are currently roughly $700 billion CLOs outstanding, but only $99 billion are held by American banks, making up at most 1.5% of the balance sheet at the largest holders such as J.P. Morgan Chase in Q1 2020. The rest was held by institutional investors and insurance funds, many of whom were forced to sell these CLOs to big banks at steep discounts during the height of the Covid19 recession. However, with how interlinked global markets are, banks no longer act as the sole lenders, instead hedge funds and other institutional traders take on much of the risks in loans (allowing banks to hedge). Without the liquidity provided by these funds, the credit market has no way to manage risk and will contract.

Why we haven’t experienced a crisis yet

The Fed has promised to be a buyer of last resort for CLOs, preventing investors from panic-selling CLOs despite that many of the companies have essentially no way to repay their debts with Covid (as there are fewer customers/harder to employ people). In effect, the Fed has artificially kept prices from falling for now, agreeing to (effectively forever) buy toxic assets with debt owned by the American people, which seems fair to no one. Furthermore, this promise to be a “buyer of last resort” has incentivized insane risk taking (if you know stocks can’t crash and will go only up, why wouldn’t you leverage a long position), which primes the market for an even greater crash. In fact, investors have begun taking out equity on their homes at all time highs (taking out nearly $152.7 billion, a 42% increase from 2019), although some analysts disagree with a housing bubble. If housing prices go in the red, the foreclosures might cause another 2008 style crisis. We already see this speculation with investors FOMOing into risky dreams and kickstarters or initial offerings that end up worthless. Currently, investors are buying dreams and making it big. Now that people are beginning to expect a market recovery, what happens if this supporting floor is removed?

What are the risks for CLOs? [Sorry, I rushed the next bits to get it out before Tuesday)

1. With rising interest rates, these assets would lose even more value. If the Fed ever stepped away for markets, this systemic risk will prevent the Fed from raising rates to curb inflation. Likely, the Fed will let these assets crash slowly. If hedge funds begin to collapse, liquidity might dry up in markets, causing a panic crash.
2. Wary of rising interest rates and poor economic conditions, credit insurers are already starting to be more reluctant to issue insurance on loans. This reluctance prevents banks and institutions from offering loans (as they’re taking more risk than they can justify), contracting the credit market and driving interest rates even higher.
3. This self-reinforcing credit contraction might lead to a collapse.

What are signs that we’re seeing this collapse?

Greensill Capital- Once a major provider of loans to Liberty Steel, an indebted UK steel company, Greensill Capital effectively went under when its assets became worthless as they could not be valued. This is in part because CreditSuisse refused to provide funds backed by Greensill’s basket of loans since the insurance company Tokjio Marine refused to cover its risky loan assets. The liquidity crisis drove Greensill Capital to bankruptcy. As credit contracts and interest rates rise, we will see this continue, moving on to our second recent example. While 10 billion is not a huge amount for a hedge fund that loaned out nearly $140 billion in both 2019 and 2020, it makes it clear that these highly leveraged credit providers can quickly go under if they make even small losses or credit insurers begin to panic. While a single provider is unlikely to bring effects like Lehman Brothers, one more collapse will harken back to 2008.

Barak fund-A $1 billion fund in Africa. Like Greensill Capital, Barak became trapped in illiquid funds, causing a liquidity implosion as it couldn’t cut losses. The loan market is often highly illiquid, despite the extensive QE pumping through markets, priming it for an implosion. Without such credit being extended to companies, the wheels of finance might come grinding to a halt.

What are signs of systemic damage to the US?

1. Although companies will try to pass inflation costs onto customers, Americans long used to certain prices might simply cut spending, which will reduce overall GDP and economic growth. With decreased demand, companies are likely to make less profits, reducing returns.
2. To control its debt, the US might try to raise taxes to redistribute wealth and pay interest on its debts as interest rates rise. This will punish American companies and decrease profits, which the markets largely expect to make nominally more with inflation.
3. If taxes do rise, there might be capital outflow from the US, reducing economic growth.
4. Commodities such as fertilizer, oil, and lumber are all in an exponential bull market. While many of these costs have not been pushed onto the consumer yet, companies will either take losses or pass on these costs to customers. Currently with quarantine, demand for gasoline and housing have gone down slightly (2.3% Y/Y for private housing). Once quarantine ends, demand is set to rise, further increasing costs for companies and pushing prices up. Note: this is arguably saying that inflation is bound to happen and that the government will be forced to contract credit to control it by raising interest rates, which could cause problems in other asset classes (see CLOs and below)
5. Jobless numbers have not recovered. This represents systemic damage to American productivity that might not recover. So long as stimulus checks continue, these people might still participate in demand, but without a proper workforce to produce goods, this artificial demand can only go to inflation. With reduced productivity and demand, companies might see falling profits.

Below this is mostly speculation, so I did not include it in my summary later.

1. In 2020, share buybacks are expected to have dropped nearly 30%. While we might see some recovery making this point somewhat negated, if share buybacks fail to recover, it could represent reduced demand.
2. I’m not sure I agree with this assessment, but Goldman Sachs economist David Kostin believes that households will make up the majority of demand for equities in 2021. Even with an increase to $350 billion from $100 billion, such funds will likely go toward hype stocks (preventing real growth as many high-flying tech stocks already sit on too much cash and won’t issue new equity, so the money is merely changing hands between investors) and would compose less than 1% of the more than $40 trillion equity market (not even including derivatives markets).
3. With the end of repayment holidays, retail investors will start to spend more money in the active economy (rather than financial markets). While this might be good for the real active economy, it will cause an outflow from financial markets, potentially leading to a sudden collapse. Instead, this money will flow toward rent and food; however, whether landowners will push this towards further financial markets cannot be predicted, so this is a rather weak argument.

Outlook:

The Fed will likely recognize that as the repayment forbearance ends, households will be squeezed for cash, so it is not prepared to raise interest rates yet. Furthermore, rising interest effects could cause a systemic crash as liquidity dries up as risk-takers (credit insurers and hedge funds) go insolvent from rising interest rates.

However, urban CPI has risen just over 2.6% from its March 2020 lows, all while a quarantine ostensibly crushed demand since people largely stayed at home, so while the Fed has implied it will wait for the average inflation to hit 2%, when inflation seems ripe to exceed the amount, the Fed must take action.

However, the Fed fears crashing markets that are hesitantly recovering and thrusting the economy back into a crisis; furthermore, the Fed cannot reenact the original SLR ratio because banks are necessary to take in increased deposits with the incoming stimulus checks. However, the Fed could potentially modify it so banks must begin deleveraging.

In effect, the Fed is stuck between a rock and a hard place. Unable to raise interest rates, the Fed can only watch as prices continue to rise. Most likely, the Fed will try to modify the SLR ratio to put a limit on bank risk without shocking the system. (In fact, some banks are refusing to accept stimulus bills until March 17 in an attempt to potentially influence the Fed) The Fed is unlikely to change current QE policy in a bid to avoid shocking markets. However, I would expect negative forward guidance for the next FOMC meeting, which could send markets downward as investors are relatively dovish on Fed yields currently and have priced it in. A deviation from this could send the markets downward. Nevertheless, I highly doubt that the Fed will take any real action to reduce QE or significantly raise Fed Funds rate targets. Stimulus checks will likely give the markets a final push because most participants in surveys imply they intend to use the stimulus checks toward financial assets (or paying off debt), not demand for goods.