Collateralized Loan Obligations: Reason to Worry?

Collateralized Loan Obligations: Reason to Worry? 1

There is every reason to worry about how bad things will get to be in the US and UK, which are engaging in close to the worst response to the coronavirus imaginable. For instance:

However, there has also been the rise of a post-financial-crisis genre of writing which gets worked up about all sorts of alleged abuses and bailouts. Mind you, I am not denying that there has been and continues to be all sorts of chicanery and stealth payoffs. In fact, there is still rampant bad conduct in private equity, which is the biggest single source of fees to Wall Street. Yet that hardly ever gets reported because it takes quite a lot of tradecraft to understand how the scams work, and the industry has done a terrific job of creating a code of omerta and keeping key documents well out of public view. The flip side is that there are some self-styled financial writers that have gotten severely exercised about things that are not consequential and not signs of distress or chicanery (and I’m not going to belabor them now, it wasn’t worth fighting those fights when those topics were warmer because the priors were too strongly lined up on the other side).

Let’s turn to collateralized loan obligations. The question is how badly have they been hurt so far and what might happen later?

The reason people get concerned about CLOs is that superficially, they are similar to the CDOs that blew up the economy so understandably laypeople get concerned that complexity is yet again hiding big time risk bombs.1

The short version is that they look to be holding up fine. Only the equity tranches seem to be at risk and those people got bigger upside in return for standing first in line to take losses. Now perhaps some of those equity tranche buyers will turn out to be loss sensitive, highly leveraged players who will fall over, but I haven’t heard anything yet that indicates that. If knowledgeable players know otherwise, please speak up.

Given the real possibility, as even Bloomberg points out tonight, that a worse-case coronavirus scenario is entirely possible (no vaccine or effective treatment any time soon), the damage could metastasize to levels that make current gloomsters look like sunny optimists. And if the real economy collapses to very diminished levels, the odds of political fracture also becomes high. It’s not hard to see getting to a de facto debt jubilee, not simply because no one can pay, but also because it becomes untenable to enforce many financial contracts.



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