CLOs: Stress points in times of Covid-19

Joe Rennison and Robert Smith report in today’s Financial Times (14 May 2020) that the Collateralised Loan Obligations (CLO) which have been booming and has helped the rise of private equity, could become vulnerable if the level of corporate defaults rise in the current context of Covid-19 pandemic. This could exacerbate the current economic and financial problems just as structured financial products did to contribute to the financial crisis of 2007-09. The CLO market has more than doubled since the last financial crisis. When private equity firms that generate the loans that go into CLOs also manage the structuring of these products, the consequent conflict of interest could result in dilution of standards.

While the FED interventions have helped save some ground after the initial setback following the onset of the pandemic, further defaults and downgrades could result in a spiralling downward effect. What it shows is that the global financial system is still best with the heady cocktail of opaqueness mixed with leverage and complexity garnished with poor quality credit.

FT quotes BankAm to say that “around a quarter of the loans held by CLOs have already been downgraded, …and last month rating agencies put more than 1,000 tranches of CLO debt on review for downgrade.”

Norinchukin Bank, known as Nochu, Japan’s largest agricultural lender which has managed savings of farmers and fishermen for over a century, is “the whale of the CLO market” with holdings worth $75bn. As in 2007/08, a few players seem to be shaping the market. And unlike 2007/08, the hit from credit default will not start from one corner of the world, but could be a more or less simultaneous hit across the world – as the effect of the pandemic cuts across sectors and jurisdictions. With downgrades looming, investors like Nochu which only wanted AAA-rated securities might be looking at a higher capital requirement. But, at the same time, in what might look paradoxical, diluted loan standards could mean less ability to force bankruptcy. Does that mean CLOs could escape the worst outcomes from the pandemic? We will have to wait and watch.  

I feel that the global financial markets and regulators are better prepared than they were in 2007/08, there are more robust shock absorbers in place, and the monitoring of danger signals is more frequent and well-directed. It is doubtful that hubris would come visiting again.

© G Sreekumar 2021

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