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Collateralised loan obligations: why these obscure products could cause the next global financial crisis

CLOs are said to be far safer than the derivatives that nearly brought down the global banking system in 2007 – but the cracks are beginning to show.

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On the money? Sean Pollock/Unsplash, CC BY-SA

At the heart of the global financial crisis of 2007-09 was an obscure credit derivative called the collateralised debt obligation (CDO). CDOs were financial products based on debts – most notoriously, residential mortgages –which were sold by banks to other banks and institutional investors.

The profitability of these CDOs largely depended upon homeowners’ ability to repay their mortgages. When people began to default, the CDO market collapsed. And because CDOs were interwoven with other financial and insurance markets, their collapse bankrupted many banks and left others requiring government and central bank support.

Many thought this would put an end to the market for complex structured credit derivatives, but it didn’t. As of 2021, a close cousin of the CDO known as the collateralised loan obligation or CLO was approaching the equivalent value of the CDO market at its peak. A record number of CLOs were issued in August, and the market as a whole is approaching US$1 trillion (£726 billion) in value. Many within the financial services industry say that there is nothing to worry about, but there are good reasons why they could be wrong.

How CLOs differ from CDOs

Collateralised loan obligations are underpinned not by mortgages but by so-called leveraged loans. These are corporate loans from syndicates of banks that are taken out, for example, by private-equity firms to pay for takeovers.

Proponents of CLOs argue that leveraged loans have a lower record of defaults than subprime mortgages, and that CLOs have less complex structures than CDOs. They also argue that CLOs are better regulated, and carry weightier buffers against default through a more conservative product design.

See-saw with a big dollar at one end
Leveraged loans: the new derivative base par excellence. Eamesbot

None of this is untrue, but this do not mean risk has disappeared. Mortgages, for example, had low rate of defaults in the 1990s and early 2000s. But since CDOs enabled banks to sell on their mortgages to free up their balance sheets for more lending, they began lending to riskier customers in their search for more business.

This relaxation of lending standards into subprime mortgages - mortgages issued to borrowers with a poor credit rating - increased the eventual default rate of CDOs as people who could ill afford their mortgages stopped repaying them. The danger is that the same appetite for CLOs may similarly reduce standards in leveraged lending.

In one respect, CLOs may even be worse than CDOs. When homeowners failed to repay their mortgages and banks repossessed and sold their houses, they could recover substantial amounts that could be passed through to CDO investors. However, companies are rather different to houses – their assets are not just bricks and mortar, but also intangible things like brands and reputation, which may be worthless in a default situation. This may reduce the amount that can be recovered and passed on to CLO investors.

Network effects

In a recent paper, we examined the similarities between CDOs and CLOs, but rather than comparing their design, we examined legal documents which reveal the networks of professionals involved in this industry. Actors working together over a number of years build trust and shared understandings, which can reduce costs. But the mundane sociology of repeat exchanges can have a dark side if companies grant concessions to each other or become too interdependent. This can drive standards down, pointing to a different kind of risk inherent in these products.

The US-appointed Financial Crisis Inquiry Commission (FCIC) found evidence of this dark side in its 2011 report into the CDO market collapse, underlining the corrosive effects of repeat relationships between credit-rating agencies, banks, mortgage suppliers, insurers and others. The FCIC concluded that complacency set in as the industry readily accepted mortgages and other assets of increasingly inferior quality to put into CDOs.

Unsurprisingly, creating CLOs requires many of the same skill sets as CDOs. Our paper found that the key actors in the CDO networks in the early 2000s were often the same ones who went on to develop CLOs after 2007-09. This raises the possibility that the same industry complacency might have set in again.

Sure enough, the quality of leveraged loans has deteriorated. The proportion of US-dollar-denominated loans known as covenant-light or cov-lite – meaning there are fewer creditor protections – rose from 17% in 2010 to 84% in 2020. And in Europe, the percentage of cov-lite loans is believed to be higher.

The proportion of US dollar loans given to firms that are over six times levered – meaning they have been able to borrow more than six times their earnings before interest, tax, depreciation and amortisation (EBITDA) – also rose from 14% in 2011 to 30% in 2018.

Before the pandemic, there were alarming signs of borrowers exploiting looser lending standards in leveraged loans to move assets into subsidiaries where the restrictions imposed by loan covenants would not apply. In the event of a default, this limits creditors’ ability to seize those assets. In some cases, those unrestricted subsidiaries were able to borrow more money, meaning the overall company owed more in total. This has strong echoes of the financial creativity that drove riskier borrowing in 2005-07.

Picture of a network with office workers as nodes
Has the network behind CLOs become too cosy? Aelitta

So how worried should we be? The CLO market is certainly very large, and corporate defaults could soar if it turns out that the extra money pumped into the economy by central banks and governments in response to the COVID crisis provides only a temporary reprieve. The major buyers of these derivatives again seem to be large, systemically important banks. On the other hand, according to some accounts, these derivatives are less interwoven with other financial and insurance markets, which may reduce their systemic risks.

Nevertheless the market is at least large enough to cause some disruption, which could cause major ructions within the global financial system. If the networks behind these products are becoming blind to the risks and allowing CLO quality to slowly erode, don’t rule out trouble ahead.

Adam Leaver received funding from the Independent Social Research Foundation for this research. He is a member of the Labour Party and sits on the board of the Corporate Accountability Network.

Daniel Tischer and Jonathan Beaverstock do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.

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Economics

Peter Schiff: Transitory Permanence

Peter Schiff: Transitory Permanence

Via SchiffGold.com,

The inflation that we were emphatically told would be transitory and unmoored continues to persist and entrench. As the troubles gather momentum Washington is doing its best to ignore..

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Peter Schiff: Transitory Permanence

Via SchiffGold.com,

The inflation that we were emphatically told would be transitory and unmoored continues to persist and entrench. As the troubles gather momentum Washington is doing its best to ignore the problem or actively make it worse.

The latest batch of data shows that the Consumer Price Index rose 5.4% in September, the 5th consecutive month that year over year inflation came in at more than 5%. The figure rises to 6.5% if we project the inflation levels of the first 9 months of 2021 to the entire calendar year. The last time we had to contend with numbers like these, Jimmy Carter was telling us all to put on our sweaters.

Recent developments should be sounding the alarms. Whereas earlier in the year inflation was largely driven by supercharged price increases in narrow sectors, such as used cars and hotel rooms, it’s now occurring in a much wider spectrum of goods and services.

In September, the cost of used autos fell month over month (but are still up 24% year over year), but that didn’t help the overall CPI, which saw increases just about everywhere else. Over the past 12 months: beef prices are up 17.6%, seafood prices up 10.6%, home appliances up 10.5%, furniture and bedding up 11.2%, and new cars up 8.7%.

Even more alarming is that oil is up over $80 per barrel for the first time in almost 10 years and many analysts see $100 in the near future. That has translated to more than a $1 increase in per gallon gasoline prices, a 50% increase in a year. Home heating oil prices are already up 42% year over year and are expected to spike up again when winter demand peaks.  For many low-income residents of the North and Upper Midwest, these types of increases could be very hard to bear, particularly if we have a cold winter.

As I have said many times before, the biggest flaw in the way we measure inflation (and there are many of them) is how the government deals with housing. While the Case Shiller Home Price Index is up more than 20% year over year, and national rents are up more than 12% over the same time frame, the CPI has largely ignored these increases in housing costs. Instead, the government relies on the dubious and amorphous concept of “Owners Equivalent Rent” which asks homeowners to guess how much they would have to pay to rent a house of similar quality to the one they to the one they own. Conveniently, that meaningless figure, which constitutes almost 30% of the total CPI, is only up 3% year over year. If actual rent increases were used instead, the CPI would be almost three full percentage points higher.

In fact, relying on the government to tell us the truth about inflation is a bit like asking high school students to grade their own report cards. There are countless incentives that exist institutionally for the government to underreport inflation. It allows them to make stealth cuts to Social Security, to create higher nominal incomes and capital “gains” to tax, and to minimize the interest rates it pays on over $28 trillion in debt as inflation. But since GDP is adjusted for inflation, it also makes economic growth appear higher than it really is.  The methodology for computing the CPI index was specifically designed to minimize the impact of rising prices. But I don’t believe that this is a conspiracy. Once you understand how institutional bias works, how careers are made by finding new plausible ways to underreport inflation, and how they are ruined by claiming the opposite, you can see how the numbers get farther away from reality with each passing year.

But the disconnect has become so obvious that top officials at the Federal Reserve and the Treasury Department have begun warning the public to prepare for higher prices. In her latest exercise of goal post moving, Treasury Secretary Janet Yellen said, “I believe that price increases are transitory, but that doesn’t mean they’ll go away over the next several months.” We can expect that months will soon turn into years, as the definition of “transitory,” gets ever more elastic.

This week the government announced that the inflation-adjusted cost of living increases for Social Security payments in 2022 will be 5.9%, the highest such increase since 1982. In addition to throwing yet another log on the government deficit fire, the increase is a direct admission that inflation is not going away.

Despite the marginal increase in wages that the Biden Administration likes to talk about, or the cost of living increases for our seniors, the average American makes less money. After adjusting for inflation real hourly earnings in the United States have dropped 1.9% so far this year. This is the stagflation that I have been warning about. Welcome back to the Carter Administration. We can expect Joe Biden to break out our sweaters if home heating bills get too high this winter.

Team Biden has been working overtime to suggest that the price increases and supply shortages are resulting from temporary bottlenecks at port facilities. Imports are particularly sensitive as our trade deficit has widened to record levels in recent months, making Americans ever more reliant on overseas goods. To combat the problem the Administration has ordered that some ports begin to operate 24 hours a day. (Left unsaid was the very fact that American ports – due to the strength of the Longshoreman’s Union – operate at very spare schedules versus foreign counterparts).

But the effect of this order will be far milder than the Administration hopes. Firstly, it is unclear how many port facilities will comply. Some have noted for instance that the Port of Los Angeles agreed to go 24 hours at only one of its six docks. (Currently, the wait time to enter that port is approaching three weeks). And secondly, most industry analysts note that the problem is not the hours of the dock facilities themselves but the shortfalls of the domestic trucking industry to move the goods once they arrive. Not only are we struggling with a lack of drivers, who struggle with government regulations that sharply limit the number of hours they are allowed to drive, but a lack of shipping containers to put back on the ships. Since many ships refuse to leave unloaded, which greatly reduces their profitability, America needs to first solve a host of problems to get the ports in better order.

But what we are seeing in a larger sense are the fruits of 15 years of bad investments in things that we don’t need and very little investment in the things we do. The ultra-low interest rates that have become the bedrock of our bubble economy have channeled investment capital into the wrong places. These low rates have encouraged corporations to borrow recklessly to buy back shares and inflate stock prices. Such moves have enriched shareholders but have done little to expand productive capacity.

Low rates have also led to runaway speculation in untested and unneeded industries. We have seen massive investments in social media, e-commerce, entertainment, cryptocurrencies, financial technology, and most recently Non-Fungible Tokens (NFT’s). As a result, we have really built out our capacity to post videos, buy things online, and pay for them in new ways. But we have invested comparatively little in boring industries like manufacturing, energy, transportation, and agriculture. As a result, we have all sorts of ways to buy stuff, and gimmicks for how to pay for it later, but we lack the capacity to produce and distribute all the goods we want to buy in the first place.

What’s worse is that given the current policies of the Biden Administration, none of that is going to change anytime soon. His expanded social safety net programs, overly generous unemployment benefits, higher taxes and regulation, and unneeded vaccine mandates are discouraging workers from working and employers from hiring. The American workforce is more than five million workers smaller than it was before the pandemic. That is not an accident. If the Democrats get their caucus together long enough to pass even a slimmed-down version of Biden’s Build Back Better plan look for all these problems to get worse.

With fewer workers working, supplies of goods and services have diminished. Government will look to replace the lost production with even more monetary and fiscal stimulus, which just leads to more inflation, financial speculation, and rising asset prices, largely benefiting the wealthy, and falling the hardest on the poor who have no appreciating assets to compensate for the rising cost of living.

But rather than fixing the problem, our current leaders are mostly worried about equity and diversity. The five leading candidates to replace Jerome Powell, if he is not renominated, all are either female or African American. Now I have no problems with hiring women or minorities in key positions. But if all your candidates come exclusively from those groups, then it’s clear that identity is more important than competency at this moment in time. But if there was ever a time that we needed competence, it’s now.

Tyler Durden Fri, 10/22/2021 - 09:10

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Spread & Containment

UK Banks – Digital Dinosaurs

UK Banks – Digital Dinosaurs

Authored by Bill Blain via MorningPorridge.com,

“Tuppence wisely invested in the bank…”

As UK bank reporting season kicks off, the dull, boring, predictable UK banks should look good. But the reality…

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UK Banks – Digital Dinosaurs

Authored by Bill Blain via MorningPorridge.com,

“Tuppence wisely invested in the bank…”

As UK bank reporting season kicks off, the dull, boring, predictable UK banks should look good. But the reality is they are dinosaurs – their failure to digitise and evolve leaves them vulnerable to tech-savy FinTechs and Challenger filling their niche. If the future of modern finance is a Tech hypersonic missile… British Banks are still building steam trains. 

Today see’s the start of the UK bank reporting season. Yawn….

I wrote a piece for the Evening Standard y’day – Another set of numbers to disguise the rot. (I’ve reused some of it this morning – lazy, eh?) Exactly as I predicted in that note, Barclays came in strong this morning with a decent lift from its investment banking businesses. Lloyds and HSBC will also produce acceptable numbers and limited losses on post pandemic recovery.  The sector outlook looks positive, the regulator will allow them to increase dividends, and there is higher income potential from rising interest rates.

But… would you buy the UK banks?

They face substantial market and ongoing pandemic risk. The cost of economic reality falls heavy across them all. This morning the headlines are about Medical groups screaming out for a renewal of lockdown measures to protect the NHS – a move that will 100% nail-on recession and cause multiple small businesses to give up. The threat of recession in the UK is pronounced – exacerbated by global supply chain crisis and risks of policy mistakes. The worst outcome for banks would be stagflation resulting in exploding loan impairments.

Lloyds is the most vulnerable to the UK economy – hence it’s underperformed the others. Even without renewed Covid measures, potential policy mistakes by the Bank of England in raising interest rates too early, or by government by raising taxes and austerity spending, will hit business and consumer sentiment hardest, causing the stock prices to crumble back towards its low back in Sept 2020 when it hit £24.72. It’s got the largest mortgage exposure – but no one really expects a significant housing sell-off. (When no-one expects it – is when to worry!)

If you believe the UK’s economic potential is under-stated, then Lloyds has the best upside stock potential among the big three. If the economy recovers strongly, Lloyds goes up. If it stumbles, then so will Lloyds!

Barclays is a more difficult call. It’s a broader, more diversified name. It retains an element of “whoosh” from its markets businesses – which have delivered excellent returns from its capital markets businesses fuelled by low rates, but it also runs a higher-than-average reputational risk for generating embarrassing headlines. But, when the global economy normalises, higher interest rates will impact the fee income of all the investment banks, thus impacting Barclays to a greater extent than Lloyds. Barclay’s international business gives it some hedge against a UK economic slide.

HSBC is the most complex call. The UK banking operation is a rounding error compared to the Bank’s Hong Kong business. The bank is pivoting towards Asia, orbiting China and other high-growth Far East economies where it seeks to attract rising middle-class wealth. It’s underperformed due to a distaste among global investors for its China business, but also the perception it’s just too big a bank to manage effectively.

If its China strategy was to pay off, it will be a long-term winner. But that’s no means certain – Premier Xi’s crackdown on Chinese Tech threatens to morph into a China first policy, and the space for a strong foreign bank in China’s banking system looks questionable, even as the developing crisis in real-estate could pull it lower.

Ok – so good for UK banks…

Whatever the respective bank numbers show this week, the banks will remain core holdings for many investors. Generally, big banks are perceived to be “relatively” safe. Regulation has reduced their market risk profiles, and strengthened capital bases since the post-Lehman unpleasantness in 2008 which saw RBS rescued by government.

Conventional investment wisdom says the more “dull, boring and predictable” a bank is, the more valuable it will be perceived in terms of stable predictable dividends, sound risk management, and for not surprising investors. Strong banks are perceived to be less vulnerable to competition with deep moats around their business.

Since 2008 that’s changed – in ways the incumbent banks have completely missed. The costs of entry have tumbled as banking has evolved into a completely different service. New, more nimble Fin-Techs like Revolut, digital challenger banks such as Starling, and cheaper foreign competitors, including the Yanks, are not only eating their lunch, but dinner as well.

The old established UK banks don’t seem to have a clue it’s happening. These incumbent banks look like dinosaurs wondering what that bright shiny light getting bigger in the sky might be. Despite proudly boasting of hundreds years of history, they are constrained by old tech ledger systems and never built centralised data-lakes from their information on individuals or the financial behaviours of crowds to improve and develop their services and income streams.

The future of banking is going to be about Tech and how effectively banks compete in a marketplace of online digital facilities and services. Banks that you use tech smartly will see their costs tumble, freeing up resources to do more, better! (When I ran a major bank’s FIG (Financial Institutions Group) about 100 years ago – the best banks were those with lowest cost-to-income ratio!)

There is an excellent article outlining FinTechs and Challengers from Chris Skinner this morning: Europe’s Challenger Banks are Challenging (and worth more than the old names). Let me pluck a bite from his piece: “Revolut is the most valuable UK tech start-up in history and the eighth biggest private company in the world, worth an estimated US$33 billion, according to CB Insights. Revolut has more than 16 million customers worldwide and sees over 150 million transactions per month.”

The new generation of nimbler Fin Techs and Challengers can innovate product offerings with sophisticated new systems and software. In contrast, UK bank IT departments are engaged in digital archaeology.  I understand only 17% of Senior Tech positions are held by women. Within the banks, I’m told its still a boys club, where the best paid IT jobs are for ancient bearded D&D playing coders brought into to patch 50 year-old archaic systems. Legacy systems leave the big banks with impossible catch up costs.

It’s probably unfair to say the big UK banks don’t know what’s happening – their management can’t be that unaware? Surely not…. But…. Maybe..

Although the banks brag how well diversified they are with over 37% of UK board members female – how much have they really changed? Hiring on the basis of diversity is a fad. At the risk of lighting the blue-touch paper and this comment exploding in my face, I would hazard to suggest the appointment of senior ladies who’ve worked their way up the existing financial system simply risks confirmation-bias on how things are conventionally done in banking.

They might do better hiring outside movers and shakers – rather than listening to themselves.

The bottom line is its not just their failure to innovate tech that’s a crisis. Over the years the UK banks have become increasingly sclerotic – slow to shift and adapt. The middle to senior levels of banking are hamstrung by bureaucracy, a satisficing culture, stifled innovation, a compliance fearful mindset, and senior management fixated on impressing the regulators first and foremost.

If the future of modern finance is a Tech hypersonic missile… British Banks are still building steam trains.

Tyler Durden Fri, 10/22/2021 - 05:00

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Economics

Guest Contribution: “How far to full employment? – An update”

Today, we are fortunate to present a guest contribution written by Paweł Skrzypczyński, economist at the National Bank of Poland. The views expressed herein are those of the author and should not be attributed to the National Bank of Poland. Back…

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Today, we are fortunate to present a guest contribution written by Paweł Skrzypczyński, economist at the National Bank of Poland. The views expressed herein are those of the author and should not be attributed to the National Bank of Poland.


Back in July 2021, when How far to full employment? was posted on Econbrowser, nonfarm payroll employment, as of June 2021, was 4.4% below pre-pandemic peak level. Since that time the U.S. economy added nearly 1.8 million jobs (including revisions), however the employment shortfall relative to February 2020 level was still -3.3% as of September 2021. This was among others due to the Delta surge that slowed hiring especially in August and September. So, how far is the labor market behind full employment state as of the third quarter of 2021? Calculating the deviation of employment from trend, according to the approach proposed by Aaronson et al. (2016), revealed back in July that in the second quarter of 2021 the employment gap was -2.8% (-4.3 million jobs). The same exercise with currently available data vintages and the same July projections from CBO, leads to the outcome of -1.4% (-2.1 million jobs) in the third quarter of 2021, of which roughly -2.4 million results from the labor force participation rate decline below potential level and around -0.4 million from unemployment rate being above natural level (Figure 1). The remaining +0.7 million deviation results from the population and ratio contributions combined (Figure 1). At the same time second quarter gap was revised up to -3.7 million jobs.

Figure 1. Employment gap decomposition (millions of jobs)

Source: own calculations based on BLS, BEA and CBO data.

So, when can one expect this gap to close? If one assumes that the pace of job creation is 500k per month (in the third quarter the average pace was 550k jobs per month) the gap would already reach +906k jobs in the first quarter of 2022. Cut that pace in half and you get a +150k jobs gap in the second quarter of 2022. Let’s hope the first option is more likely.

 

References

Aaronson D., Brave S. A., Kelly D., 2016, Is there still slack in the labor market?, Chicago Fed Letter 359, Federal Reserve Bank of Chicago.

An Update to the Budget and Economic Outlook: 2021 to 2031, Congressional Budget Office, July 2021.

 


The post written by Paweł Skrzypczyński.

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