CDOs Then CLOs Now

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US leveraged loan downgrade ratio hits staggering 43:1 as COVID-19 stalls market
S&P Global Market Intelligence JUN 4, 2020

"In their optimistic scenario — where restrictions lift in May and life gets back to normal by June — 9% of leveraged loans would default within a year. If lockdowns are in effect until June and normalcy returns at the end of August, defaults would hit 14% of loans, they said. In the worst case — the virus keeps returning in waves until the middle of next year — UBS sees the rate at 22%."
Quote from UBS Investment Bank via Bloomberg/FinancialPost May 2020

​Weak Hands

More bullet points from the June 4, 2020 S&P Global Market Intelligence report.

• "Collateralized loan obligations, the largest investor segment in the $1.2 trillion U.S. leveraged loan asset class, are exceeding their structural limits for lower-rated debt at eye-watering numbers."
• "As a leading indicator, rising downgrades also typically precede a period of increased defaults."
• "The downgrades that have come at breakneck speed are also predominantly at the lower end of the ratings spectrum, changing the composition of the B- cohort significantly."
• "At the lower rung, Morgan Stanley strategist Srikanth Sankaran expects that nearly a fifth of the loan market could transition to CCC as a result."

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​The Looming Bank Collapse - The U.S. financial system could be on the cusp of calamity. This time, we might not be able to save it.
by Frank Partnoy The Atlantic JUL-AUG 2020 Issue

TEXT SNIPPET:
 
Like a CDO, a CLO has multiple layers, which are sold separately. The bottom layer is the riskiest, the top the safest. If just a few of the loans in a CLO default, the bottom layer will suffer a loss and the other layers will remain safe. If the defaults increase, the bottom layer will lose even more, and the pain will start to work its way up the layers. The top layer, however, remains protected: It loses money only after the lower layers have been wiped out.

Despite their obvious resemblance to the villain of the last crash, CLOs have been praised by Federal Reserve Chair Jerome Powell and Treasury Secretary Steven Mnuchin for moving the risk of leveraged loans outside the banking system. Like former Fed Chair Alan Greenspan, who downplayed the risks posed by subprime mortgages, Powell and Mnuchin have downplayed any trouble CLOs could pose for banks, arguing that the risk is contained within the CLOs themselves.

These sanguine views are hard to square with reality. The Bank for International Settlements estimates that, across the globe, banks held at least $250 billion worth of CLOs at the end of 2018. Last July, one month after Powell declared in a press conference that “the risk isn’t in the banks,” two economists from the Federal Reserve reported that U.S. depository institutions and their holding companies owned more than $110 billion worth of CLOs issued out of the Cayman Islands alone. A more complete picture is hard to come by, in part because banks have been inconsistent about reporting their CLO holdings. The Financial Stability Board, which monitors the global financial system, warned in December that 14 percent of CLOs—more than $100 billion worth—are unaccounted for.

​Read the hole story by Frank Partnoy  at The Atlantic

​Currencies May See Wild Swings if Slow Growth Breaks CLO Market

by Dimitri Zabelin Analyst, MAR 2019 Full Report with Charts Here

HOW CAN A GLOBAL SLOWDOWN TRIGGER A CLO COLLAPSE?
As global demand wanes, consumers begin to spend less, business revenue streams dry up and investors pivot away from chasing yields and more toward preserving capital. Corporations that took out these covenant-lite loans – that were then securitized into a CLO – then face mounting pressure as their ability to service their debt is compromised. The probability of an onslaught of defaults then becomes considerably higher.

Furthermore, companies that are on the hook for these loans may attempt to cut corners or lay off employees as a way to trim losses and stave off insolvency. However, in the process, they may end up breaching their covenant(s), consequently giving the lender the right to declare a default on the loan. This in turn could make many of the income-generating tranches in the CLO worthless and bring down the overall value of the security

The CLOs would then shift their position on the balance sheet from assets to liabilities, potentially putting financial institutions outside the regulatory parameters of capital requirements. This may then force them to start selling other assets to compensate for the losses they incurred on the CLOs. Consequently, a selloff iterated across multiple institutions could trigger broad-based panic and hurried liquidation across global financial markets.

HOW WOULD FX MARKETS RESPOND TO A CLO UNRAVELING?
In the event of a downturn, which is further exacerbated by a CLO collapse, anti-risk assets like the US Dollar, Japanese Yen and US Treasuries would likely gain at the expense of cycle-sensitive currencies like the Australian and New Zealand Dollars. Cycle-sensitive commodities like oil – and currencies that frequently track its movement like the Canadian Dollar, Russian Ruble and Norwegian Krone – may also suffer.

While many central banks could lower rates to combat the downturn, the exact simulative effect of further cuts may not be sufficiently conducive in restoring liquidity and confidence. Other central banks with rates at or below zero like the ECB and Riksbank may have to resort to unconventional monetary measures, though even those are sometimes not effective enough to raise inflation and stave off a slowdown.

CLOs may not be the next trigger for a recession, but they could exacerbate an economic downturn. Furthermore, the average recovery rates for defaulted loans have fallen to 69 percent from the pre-crisis levels of 82 percent. Indirectly-connected players like banks that lend to firms that are holding these instruments or have exposure to them could be at risk.

The exact extent of the CLO web remains unknown. However, what the 2008 financial crisis taught the world is that highly integrated markets are efficient but also incredibly vulnerable. This then risks an element of contagion whereby a system-wide disruption could occur. A web of interconnectedness is often welcome by all – that is, until along comes a spider.

Read the Full Report with Charts Here by Dimitri Zabelin Analyst, MAR 2019

The junk debt that tanked the economy? It’s back in a big way.
The Washington Post JUL 2018

Earlier this year (2018), after complaints from banks and dealmakers reached sympathetic ears in the Trump administration, the newly installed chairman of the Federal Reserve and the Comptroller of the Currency Office declared that previous “guidance” against lending to companies whose debt exceeded six times their annual cash flow should not be taken as a hard and fast rule.

The CLO market got an even bigger boost this year when an appeals court in Washington struck down a regulation issued under the Dodd-Frank financial regulation law that required all securitizers — the firms that bundle loans of any kind and sell pieces of the packages to investors — to retain 5 percent of a deal.

Michael Barr, a professor of law and public policy at the University of Michigan who served as point man on the financial reform effort for the Treasury in the Obama administration said, “we have now re-created the condition that led to the last crisis by making it easier to aggregate loans that are not good for investors.”

The three judges who signed on to that opinion were all appointed by Republican presidents, all have a long track record of skepticism toward regulation and regulators, and all have a long association with the conservative Federalist Society. 

THE BUYOUT OF AMERICA by Josh Kosman

Marquee private equity firms such as Blackstone Group, Carlyle Group, and Kohlberg Kravis Roberts, have grown bigger and more powerful than ever. They have also become the nation’s largest employers through the businesses they own. Journalist Josh Kosman explores private equity’s explosive growth and shows how its barons wring profits at the expense of the long-term health of their companies.

He also explores the links between the private equity elite and Washington power players, who have helped them escape government scrutiny. The result is a timely book with an important warning for us all, which unfortunately in 2020 is starting to play out. JoshKosman.com

In his 2009 book The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy, Josh Kosman described Bain Capital (started in 1984 by Mitt Romney and partners) as "notorious for its failure to plow profits back into its businesses," being the first large private-equity firm to derive a large fraction of its revenues from corporate dividends and other distributions. The revenue potential of this strategy, which may "starve" a company of capital,[179] was increased by a 1970s court ruling that allowed companies to consider the entire fair-market value of the company, instead of only their "hard assets", in determining how much money was available to pay dividends.[180] In at least some instances, companies acquired by Bain borrowed money in order to increase their dividend payments, ultimately leading to the collapse of what had been financially stable businesses.[59] Source: Wikipedia

​And in Canada

From the Office of the Superintendent of Bankruptcy Canada, here is a list of all companies that have been granted protection under the Companies' Creditors Arrangement Act (CCAA) since SEP 2009.