CLO - the new CDO?

[walkinwood]

I just read this article in the Atlantic. I'm not very knowledgeable about the complexities of our financial system, but this rang a few alarm bells.
Should it?

I hope it isn't behind a paywall.

https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/

After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.

And who owns a lot of CLOs? The big banks, of course. Oh, but they're rated AAA. Haven't we heard that before?

 

[brewer12345]

I's suggest that the bigger impact will be the sudden shut of of credit to over-leveraged risky borrowers. They will be defaulting and their collapse and liquidation will trash asset values for firms that might have otherwise survived. Yay. But all the bulls should get out there and buy equities at record valuations because somehow everything will be just ducky.

See also CMBS.

 

[djfiii]

I's suggest that the bigger impact will be the sudden shut of of credit to over-leveraged risky borrowers. They will be defaulting and their collapse and liquidation will trash asset values for firms that might have otherwise survived. Yay. But all the bulls should get out there and buy equities at record valuations because somehow everything will be just ducky.

See also CMBS.

Or, whether you're a Bull or a Bear, take advantage of the short term volatility and just buy a bunch of call options at close of trading after a massive selloff, since the trend seems to be that the underlying equity pops back the next morning. Sell your options for a nice 300% return and call it a day.

 

[brewer12345]

Or, whether you're a Bull or a Bear, take advantage of the short term volatility and just buy a bunch of call options at close of trading after a massive selloff, since the trend seems to be that the underlying equity pops back the next morning. Sell your options for a nice 300% return and call it a day.

Right, because that is not gambling at all.

 

[djfiii]

Right, because that is not gambling at all.

Yes, it's 100% gambling. I thought the sarcastic / jokey tone of my post came through via the laughy face at the end, but clearly not. So to clarify for anyone else that was confused, I am not actually advocating that people run out and buy a bunch of call options after a down day, with the intent of flipping them the next day.

 

[donheff]

I suspect Brewer got the joke and was responding in kind. He just didn't think he needed to add an emoticon.

 

[jebmke]

These are an issue but I think there are two important differences from the 2007 debacle. One, in general, I think the banks are better capitalized. That doesn't mean they have issues but their cushion is probably better. Two, I don't think there is the same problem with CDS and synthetics that amped up the problem in 2007.

 

[Scrapr]

These are an issue but I think there are two important differences from the 2007 debacle. One, in general, I think the banks are better capitalized. That doesn't mean they have issues but their cushion is probably better. Two, I don't think there is the same problem with CDS and synthetics that amped up the problem in 2007.

but can you trust S&P to rate the obligations? Watching The Big Short & other articles at the time the ratings agencies were in the pocket of issuers. "what rating do you need?"

 

[jebmke]

but can you trust S&P to rate the obligations? Watching The Big Short & other articles at the time the ratings agencies were in the pocket of issuers. "what rating do you need?"

I have no idea. I was merely pointing out the much lower risk elements related to bank reserves and synthetics (derivatives). The ratings issue may still exist. The synthetics and derivatives are what turned the securitized MBS from high grade conventional weapons to nuclear weapons in 2007.

 

[brewer12345]

The problem with CLOs is that the loans that went into these structures were the bleeding edge of the credit markets (see: "leveraged lending"). The leveraging up of shaky loans to leveraged companies in the midst of at the very least the worst recession in generations will not be pretty. The effects will be felt in the CLOs, in all "floating rate loan" funds and ETFs, loan portfolios, high yield bonds, and likely in the lower end of investment grade bonds. Start looking at who owns these instruments and you will be able to start figuring out where the problems arise.

As for derivatives, etc., I believe volumes in such products have only grown since the financial crisis. I have read that there are a bunch of investors who specifically loaded up on CDS based on the BBB tranches of CMBS because they were priced as nominal risk along with all other forms of credit risk and as commercial loans blow up en masse these tranches will probably get zeroed out.