A decade
ago, bond-like investment based on mortgages led to financial panic and the
worst recession in decades.
This time
around, collateralized loan obligations (CLOs) are threatening a new crisis.
Loans are made to risky borrowers, lending standards lowered and regulators are
easing the rules. The underlying loans are going to high-risk companies. These
CLOs are made up of loans to between 100 and 300 already indebted corporate
borrowers. Sears, that filed for bankruptcy recently, was among companies that
took the leveraged loan route.
The total
CLOs issued so far is above USD550 billion. Covenant light loans now account
for 80% of new leveraged loan market. They are the easiest to sell and floating
rates are better in a rising interest rate regime.
CLOs have
been around since mid-1990s. Multiple repayment streams funnel interest and
principal to investors. So long as the U.S. economy is strong, the pizza party
can continue. It is now one-tenth the size of the American mortgage market
(before 2008). It is larger than the junk bond market – which blew up in the
late 1980s.
Prof. Simon
Johnson at MIT, thinks a collapse wouldn’t be as bad “but it could still be
bad”.
What do you
think?
Reference
Critics wary of popular new product on Wall Street, Matt
Phillips, The New York Times, Oct 22, 2018.
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