Collateralized loan obligations, securities backed by a pool of debt such as low-rated corporate bonds, have performed well this year but attracted criticism for it.
Market observers have equated the high volume of new CLO notes in Europe and the U.S. to a resurgence of systemic risks last seen during the financial crisis.
European CLO issuance for the year to date is higher than during the same period last year, when issuance was the highest since the financial crisis with 16.8 billion euros issued in 41 transactions. In the much larger U.S. market, year-to-date CLO issuance of $71.2 billion is twice as high as in the same period in 2016, according to Bloomberg. The majority of CLOs are structured through the Cayman Islands.
Writing in the Financial Times last month, Frank Portnoy, a professor at the University of San Diego and author of “Fiasco: Blood in the Water on Wall Street,” argues that the sequel to the financial crisis has arrived and identifies collateralized loan obligations as the main culprit.
He compared CLOs to collateralized debt obligations, much more complex debt instruments that have been blamed for contributing to the financial crisis, because at the time most CDOs bundled different types of debt, such as car loans, corporate bonds and especially subprime mortgages.
This made CDOs one of the worst-performing instruments during the market meltdown from 2007 to 2009, resulting in hundreds of billions in losses.
Although most of the loans underlying the latest collateralized loan obligations are of “junk” status, Mr. Portnoy wrote, more than half the new debt is rated triple-A, signaling their risk of default is very low.
Mr. Portnoy believes the computer models used to assign triple-A credit ratings remain flawed.
“Because loan defaults can come in waves, mathematical models should account for ‘correlation risk,’ the chance that defaults might occur simultaneously,” he noted. “But the models for CLOs assume correlations are low. When defaults occur at the same time, these supposed triple-A investments will be wiped out. CLOs are just CDOs in new wrapping.”
The Loan Syndication and Trading Association in a statement responded that there is nothing “nefarious” going on.
“The suggestion that somehow the companies that CLOs lend to are unworthy because they are not investment grade seems troubling,” the LSTA said. “After all, 70 percent of rated American companies are rated below BBB/Baa3; these are important and iconic American companies such as Burger King, Avis, American Airlines and Dell, as well as many innovative middle market companies.”
The trade association said “CLO formation is strong because CLO performance has been extraordinary.” The debt instruments had provided $450 billion of financing to more than 1,000 companies. “This is something to laud, not criticize.”
The comparison with collateralized debt obligations is unwarranted, the trade body noted, because the long-term loss rate on investment grade CDO notes is much higher at 34 percent – a figure that includes the performance during the financial crisis – than CLOs, which according to rating agency Moody’s only had long-term loss rate of 0.1 percent.
The association also noted that there has never been a default on a CLO note that was rated AA or better according to Moody’s.
Not only have CLOs performed better than other asset backed securities, they were also much safer than corporate bonds, the LSTA said, citing cumulative default rates compiled by Wells Fargo in 2015. For instance, A and BBB-rated CLO note defaults were both less than 0.5 percent compared with 2 percent and 5 percent, respectively, for equivalently rated corporate bonds.
For BB-rated CLO notes and corporate bonds the difference is even larger: 2.26 percent compared with nearly 16 percent.
The LSTA also played down the correlation risk between by pointing out that CLOs must invest in loans to a diverse set of industries.
For AA-rated CLO notes to be impaired, default rates of the underlying loans would have to be nearly seven times higher than during the financial crisis and for AAA-rated CLO notes there is no default rate high enough to cause losses, the LSTA said referring to research by Bank of America.