CLOs: Another Ticking Time Bomb?

Hello and welcome back to Breaking the Dollar. Thanks for listening. I'm your host, Everett Millman. And on today's episode, we're going to be discussing CDOs and CLOs. What are they and why do they matter? Now, the quick and dirty definition of a CDO, or we'll start because that's the first one, is it's basically a package of loans. It's a bunch of separate loans that have been smashed together into one financial product, and they were one of the biggest triggers of the last financial crisis in 2007–2008. Back then, they were mainly mortgages—home loans—and you'll often hear them called mortgage-backed securities. But CDOs themselves can be made up of any type of loan, and it can be slightly confusing how this works. What do you mean when you say packaged-together loans?

The best analogy I could use is to think of an expansion baseball team. You're adding a new team to the league. The way they actually do this is every other existing team has to give up a couple of players to make up the new roster for the expansion team. Theoretically, they're supposed to be getting a full roster of major league-caliber players. But in this example, imagine that instead of them all being that quality of player, the teams threw in a bunch of subpar, minor league players who are never going to turn out to be that good. But they are baseball players nonetheless. Now you have mixed together these different qualities of players, but the package itself is still considered a professional team.

That's really what a CDO is for loans. Some of the loans are high quality, with a high credit rating, but then most of the rest of them are junkier loans—loans that are riskier. The only way you could get those loans sold to any investor is by packaging them together with some of the other good loans. When you take them as a whole, it's not as risky as the riskiest loan that's at the bottom of the barrel. Nonetheless, that means you have a gumbo of loans.

Part of the clever innovation behind gumbo is that you can take food that is about to spoil or is just older or of lower quality and mix it into the pot of the stew with everything else—all your other ingredients. That kind of masks the flavor and the lower quality of that rotting food or those vegetables that are about to go bad. That's how you can think of the loans within a CDO. Yes, there are some higher-quality ingredients, but it's really just to cover up all of the poor ingredients—all of the bad credit-rating loans that have been mixed in. That's why they bundle the loans together into something like a CDO.

How are CDOs sold? That's an important question because they are these complicated products of financial engineering, but someone has to be buying them. It's becoming a problem because the market for these things has exploded. There's a lot of demand. All the loans in the CDO that are bundled together, each one has its own credit rating, its own level of risk, and the riskier it is, the higher yield it's going to pay. Because there is a mix of these different levels of risk for each loan, they're set up in what are called tranches. Really, that's just a fancy Wall Street word for a bundle.

All the highest-rated loans are bunched together, then the middle grades, and then the low grades—the junk ratings. They're all bundled together. Let's use another analogy to illustrate how these things work on Wall Street. Think about being a commercial fisherman. The further out you go away from shore, it might be riskier, but there's a better return—you'll catch the bigger fish. Conversely, if you stay close to the shoreline, it's much safer, but you're not going to get as high of a yield or catch as many big fish.

The point is, when the storm comes, the boats close to the shoreline have a better chance of making it back safely. They have a very good chance, whereas the boats that went out into the deep sea fishing to try and get the big fish can't weather the storm. They're too far away—they're going to be lost at sea. That's how you can conceptualize the difference in risk between the different tranches in a CDO.

The high-risk loans are the ones least likely to pay your money back in the event of a default or bankruptcy, whereas the safer loans won't pay as high of a yield right now, but you'll be the first one to get to safe shore—you'll be the first one paid back in a default event. I hope you understand why banks bundle and package these loans. Nobody would buy the bad ones on their own. Nobody wants them, but if you mix them all together, from their perspective, they're diversifying their risk.

That word "diversification" is interesting because it comes up often. For investments, diversification protects you; it hedges against risk by not putting all your eggs in one basket. But when it comes to CDOs, they're all still loans. Saying the risk is diversified is misleading. For example, if you bought 50 different buildings, you might think you're diversified, but if all those buildings are on Miami Beach, they face the same hurricane risk.

That’s how CDOs work. When a few loans go bad, it's like an avalanche—a chain reaction. That’s why CDOs were a major factor in the financial crisis.

Now we have CLOs: collateralized loan obligations. They're like CDOs but with corporate debt and consumer debt instead of mortgages. These leveraged loans are riskier—companies already in debt borrowing more. It's compounding debt, like taking multiple mortgages on one house. That's the main reason why a lot of economists cite CDOs as the biggest contributing factor to how bad the last financial crisis was. It wasn't the only factor, but it may have made it much worse than it had to be. So lo and behold, we have a newcomer to the financial scene. That's basically the same thing as a CDO. The only difference is the type of loans that underpin it.

I'm talking about CLOs: collateralized loan obligations. It's really no different. I mean, they only bother to change one letter, and the word loan is almost the same as debt anyway. But CLOs have the exact same structure as CDOs. The difference, and what makes them potentially even far riskier this time around, is that the types of loans in CLOs are generally corporate debt, which are leveraged loans, and consumer debt.

It'll probably be useful to give you a brief overview of leveraged loans and how they work because it's not any old debt. A leveraged loan is for a company that is already deeply indebted. They've already taken out many loans that they're behind on potentially, and a leveraged loan is when a company borrows money to either buy out its own shareholders or to acquire another company, so it's debt on top of debt. If you want to compare it to how much worse it could be than the mortgage crisis with the housing bubble, most people weren't taking out a fourth or fifth mortgage on the same house. But that's what a leveraged loan is. It's like the company is mortgaging itself for the umpteenth time. It is compounding debt. It is debt on top of debt and is the underlying asset that gives a CLO value. To me, that seems incredibly risky, and that's the whole reason why these loans need to be bundled together to get anyone to buy them in the first place—on their own, they're not safe.

The demand for CLOs has exploded as there's more leveraged buyouts and leveraged loans made for companies. As we get to this kind of late-in-the-cycle period of the economic expansion we've been experiencing, keeping credit loose is the only thing that's kind of keeping that cycle afloat and keeping those companies from already going into default. But because they have access to more funding and they can take on debt through a CLO, it's sort of a self-fulfilling prophecy. It just feeds itself where there's more demand, and so there are more CLOs. What that naturally leads to is lower and lower quality debt making it into the CLOs because there's only a limited amount of good-performing loans out there. It's somewhat in scarce supply, but if there's still demand, these underwriters are going to put lower and lower quality debt into the CLO package. That's how you make a gumbo. You keep putting in the vegetables, but it really is not safe, and the whole point of bundling is to give the appearance of it being safe. Really, Wall Street is selling a false bill of goods there. In my opinion, that's part of their MO. All of these confusing concepts about the different ratings and how credit works and words like tranches—that's really all smoke and mirrors to confuse the consumer and investor into not knowing what's going on.

It is a somewhat accurate depiction to say that it is really just paper moving around, confusing things happening on paper. But the problem is that we as a society all deal with the consequences when these things go bust. The fund managers who actively manage some of these CLOs, mutual funds, ETFs—they don't take any of the liability. It's the rest of us who are left holding the bag. But you're probably wondering, how does that work? Why does that matter today? It's because the market for CLOs and leveraged loans has gotten so big. The average multiplier of leverage that companies have now—so how much debt they've taken on relative to how much their business is worth—is actually higher now than it was in 2008, right before the crisis. The CLO market, after basically dying right in the wake of the financial crisis when the panic was at its peak, gradually grew bigger and bigger and bigger—from a billion-dollar market to a $20 billion market about eight years ago to now a trillion-dollar market. That's why this is important. That's why it could make the next recession or financial panic even worse than the last because the stakes are higher.

So that kind of wraps up our discussion for today. As always, we'll take a question from our listeners. Remember, you can always email those to btd@gainesvillecoins.com. This week's question comes from Sharon in Alberta, Canada, and Sharon asks: How did gold do during the last financial crisis? That's an interesting question because it's important to know—is gold really a hedge against a financial panic? In the first two years after the crash, gold did remarkably well. It had basically exponential price growth where it more than doubled in that span from under a thousand dollars to $1,900 an ounce. So gold did very well. Now, the second side of that is as the economy "recovered," gold prices kind of fell back down to earth. But nonetheless, in times of crisis, yes, gold has proven to appreciate dramatically in price.

That does it for today. Thank you so much for listening. We appreciate everyone who tunes in. Be sure to join us next time when we talk about a related topic that is sort of the consumer version of leveraged loans: non-bank lending or shadow banking. It's a really interesting topic that we're going to delve into and hopefully give you some actionable advice about how to avoid falling into that trap yourself.