Collateralized loan obligations (CLOs), which bundle and sell corporate debt to investors, are increasingly viewed as a major threat to the U.S. financial system. However, such concerns ”are misplaced, driven by a misunderstanding of CLOs and their role in the banking system,” write Wharton finance professors Michael R. Roberts and Michael Schwert in this opinion piece.
Collateralized loan obligations (CLOs) have received a great deal of negative attention lately. At first glance, they look and sound a lot like the collateralized debt obligations (CDOs) that precipitated the 2008 financial crisis. Additionally, U.S. banks own over $100 billion dollars of CLO investments.
However, concerns over CLOs’ impact on the financial system are misplaced, driven by a misunderstanding of CLOs and their role in the banking system. There are reasons to be concerned about business lending during the COVID-19 pandemic. A collapse of the financial system caused by a familiar sounding acronym is not one of them.
CLOs versus CDOs
Like CDOs, CLOs purchase risky loans with money received from different groups of investors. The interest and principal payments from the loans are then distributed to CLO investors according to a specific order: senior investors get paid first, junior investors next, and equity investors last.
Any missed loan payments lead to reduced payments to the CLO investors, but in reverse order: equity absorbs losses first, then junior investors, and finally senior investors. Only after the equity and junior investors have been wiped out will senior investors experience a loss. Consequently, the CLO claims held by senior investors are typically rated AAA (i.e., very safe) because a lot of loans have to go bad before they lose any money. Junior tranches receive a range of lower ratings commensurate with their risk, and equity tranches are unrated.
This is where the similarities end.
A study by Cordell, Feldberg, and Sass (2019) shows that AAA-rated tranches of CDOs issued before the 2008 crisis lost $325 billion during the following years. In contrast, Standard and Poor’s found that AAA-rated tranches of CLOs issued before the 2008 crisis lost nothing. This performance differential stems from differences in the assets that the two vehicles bought.
The CDOs that got into trouble during the financial crisis did not buy loans, they bought junior tranches of other CDOs (mortgage-backed securities) and credit default swaps (derivatives) referencing other CDOs. The process of repackaging CDO tranches into new CDOs significantly amplifies risk, which is why senior investors in those products lost so much money.
The typical CLO holds hundreds of loans diversified across dozens of industries. Exposure to any industry is contractually limited to 15% of the loan pool, while the maximum exposure to a single company is 2%. Thus, defaults must be pervasive across all sectors of the economy to materially affect the collateral pools of CLOs.
Unfortunately, this is exactly what is happening now. Most sectors of the economy are experiencing varying degrees of turmoil. Further, lending standards have been in decline for several years, resulting in weaker protections for creditors. The combination raises the possibility that CLOs will experience large losses in the coming months.
But will those losses reach the senior investors, who are primarily banks and insurance companies? Even under the most pessimistic economic forecasts, this is unlikely.
“The process of repackaging CDO tranches into new CDOs significantly amplifies risk, which is why senior investors in those products lost so much money.”
If lenders were to recover $0.40 on the dollar for loans in default, then 60% of the loans in CLO portfolios would have to default before the AAA-rated tranches would even begin to lose money. To put that number in context, the cumulative default rate for risky debt during the worst three years of the Great Depression (1931-1933) was 31%.
If AAA-rated CLO investments default in large numbers, then the business sector will be facing its worst downturn in the history of our country. CLOs will be the least of our concerns.
The Risk to Banks
Despite the low likelihood, what if banks’ CLO investments default? Will these defaults create problems for the banking system? No.
U.S. banks hold $104 billion of CLO investments, $83 billion of which sits on the balance sheets of three banks: JPMorgan Chase, Wells Fargo, and Citigroup. As a fraction of their assets, CLO investments are 1.1%, 1.3%, and 0.9%, respectively. As a fraction of Tier 1 capital, which regulators use to measure a bank’s ability to withstand losses, CLO investments are 17%, 17%, and 14%, respectively.
If every loan in every CLO defaulted at the same time, and all of the assets securing those loans evaporated into thin air so that the lenders couldn’t recover any money, these three banks would still be left with over 80% of their equity capital, or more than $400 billion.
This is not to say that the banking system is immune from risk, including that from risky corporate loans. Corporate defaults would affect banks in many ways beyond their CLO investments. But the view that CLOs are analogous to the CDOs of 2008, and therefore will be the cause of our next financial crisis, does not comport with the facts as they stand today.