Recently, some investors have grown concerned that rising collateralized loan obligations (CLOs) could spell trouble and even cause a repeat of 2008’s financial crisis. CLOs are securitized corporate debt instruments—they pool a stream of expected corporate loan payments into a security, which is then sold to investors.
Given the economic impacts of COVID-19-related shutdowns on many businesses, some people are comparing CLOs to mortgage-backed securities (MBS) or other collateralized debt obligations (CDOs), the securities widely seen as responsible for 2008’s financial crisis. The fear is that if the economy continues to suffer due to COVID-19 institutional shutdowns, corporate loan defaults could rise, leading to a wave of CLO write-downs and default—just like CDOs in 2008.
However, Fisher Investments believes these fears overlook a key cause of the 2008 financial crisis and overstate banks’ current exposure to collateralized loan obligations.
The Key Reason Banks Struggled With Collateralized Debt Obligations (CDOs) in 2008
Despite subprime mortgage loans and related CDOs bearing much of the blame for the 2008 financial crisis, Fisher Investments believes a key cause was the well-intentioned accounting rule, FAS 157 or “mark-to-market accounting.” Mark-to-market accounting required financial institutions to value illiquid assets, like CDOs, at the most recent sale price of similar assets. Many institutions held collateralized debt obligations for their income stream, which meant they had little or no intention of ever selling them.
Critically, under mark-to-market accounting in 2008, if one financial institution sold a CDO at a loss, then others (that still held similar CDOs) were forced to write down their CDO values too—regardless of whether they planned to sell those similar securities or hold them to maturity. This created a negative-feedback loop of bank balance-sheet losses, which further forced banks to sell other CDOs to shore up their capital structures.
Importantly, FAS 157 was suspended in March 2009 and subsequently modified in the following months to allow financial institutions to differentiate between securities held “for sale” and those intended to be “held to maturity.” The “for sale” assets would be marked at most-recent sale prices, but the “held to maturity” assets would no longer incur write-downs—financial institutions could simply disclose the market value in a footnote on their balance sheets. This change helped protect financial institutions’ balance sheets and stymied the destructive negative-feedback loop of the first iteration of mark-to-market accounting.
Unlike collateralized debt obligations in the 2008 financial crisis, many collateralized loan obligations aren’t subject to mark-to-market accounting. According to S&P Global, nearly one-third of the CLOs owned by US banks were marked as “held to maturity” at the end of 2019, which should minimize balance-sheet impact if the economy hits a rough patch and some corporate borrowers start to default.
Scaling Banks’ Collateralized Loan Obligation (CLO) Risks
Though some investors fear banks today have too much money tied up in collateralized loan obligations, US banks’ exposure isn’t huge when scaled properly. At the end of 2019, US banks held nearly $100 billion of CLOs per S&P Global. While $100 billion is a significant sum in absolute terms, it represents a fraction of the $17.8 trillion held in total US bank assets, as estimated by the Federal Reserve Bank of St. Louis. So, even if CLO markets experience significant trouble ahead, US banks’ exposure likely isn’t large enough to create the huge liquidity constraints or negative balance-sheet impact CDOs had in 2008’s financial crisis under mark-to-market accounting.
Additionally, banks aren’t the only CLO investors. The Financial Stability Board estimates banks own only about 20% of outstanding CLOs globally. Further, banks’ CLO portfolio holdings tend to be the highest-quality, lowest-risk variety. For context: CLOs are divided into different parts, called tranches, generally labeled senior, mezzanine, junior and equity. Like bonds, CLO tranches are rated on credit quality and perceived risk. Senior tranches carry the highest credit quality and are paid first in the event of default. Thus, senior tranches are generally considered to have the lowest risk. Conversely, equity tranches generally carry the lowest credit quality and investors are paid last in the event of default, representing the highest risk.
According to the Federal Reserve, about 95% of the CLOs on US bank balance sheets are of the senior and lowest-risk tranche. The lower-quality, higher-risk tranches are held primarily by non-bank investors, like hedge funds. So in the event that economic conditions worsen, banks are somewhat insulated, since the highest-rated tranches are less likely to default.
US banks’ relatively small CLO exposure combined with a more favorable accounting environment are fundamental reasons Fisher Investments doesn’t think CLOs are likely to cause a 2008-style financial crisis. Further, the heavy scrutiny on these products may also help minimize potential issues within the CLO market. When seemingly everyone else is worried about something in the news, it often means markets have already priced in the risks and opportunities in that area. So, today, Fisher Investments believes investors are likely better off focusing somewhere other than headline CLO concerns to glean new, useful market insights.
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