21.06.2019 – Special report. Please buckle up for the ride to hell: the world’s stock markets are threatened by a new financial crisis. If the pessimists are right, then the events of 2008 will repeat themselves at some point. This time Collateralized Loan Obligations (CLO) could drag banks, funds and insurers into the abyss. And with it Wall Street, Nikkei, DAX and co. at the same time. Stand by – we’ll shed light on the background.
Crash prophet warns of the next bubble
A few days ago, an article with a catchy and rather apocalyptic title tore us out of our summer apathy: “The storm is coming – The Collateralized Loan Obligations bubble and the parallels to the 2008 financial crisis”. Written by Professor Max Otte, Crash Prophet and financial expert. He referred to Brian Moynihan, CEO of Bank of America, who had been critical about the CLO. Otte himself noted that he had already warned of this bubble at the 2018 Fund Congress in Mannheim.
That’s what it’s about, let’s Otte speak for himself: “Collateralized loan obligations are securitisations of loans to private individuals, but primarily of loans to companies that are either highly indebted and/or have a lower credit rating. Nonetheless, around two-thirds of these junk securities are currently rated “AAA” by the relevant rating agencies.”
The link to 2008: A CLO “is comparable to a Collateralized Mortgage Obligation (CMO), with the exception that the underlying debt is a corporate loan instead of a mortgage. With a CLO, the investor receives scheduled debt payments from the underlying loans and assumes most of the risk in the event that a borrower defaults. In return for assuming the risk of default, the investor is promised an above-average return.”
Danger of a bear market due to rising interest rates
There is a danger of being tied to the interest rate: the lending rate is tied to the US Libor, among other things. If this rises, companies would no longer be able to service their debts. Then a wave of sales to CLO threatens. Otte writes: “If the interest burden for the debtors in the CLOs continues to rise, the first of these “securities” could soon catch fire. Then – as we already know – a wave of sales would be triggered that would cause the market to collapse and dry up. We already had a foretaste of this for a few days in December 2018. Papers were no longer traded at that time because there were no buyers. The gaps in investors’ books are filled in such phases by the sale of other assets, such as shares.”
According to Otte, there is no longer any security. After the financial crisis, the US supervisory authorities introduced a risk retention of 5 percent for issuers. This was overturned by a court order in February 2019. According to Otte, the entry hurdles for new market participants are thus lower.
Fast money on the hunt for returns
We started researching, which proved to be difficult in view of the thin reporting situation. The borrowers are small and medium-sized companies, often start-ups. According to a Bloomberg report from December 2018, these are Harbor Freight Tools, a company that sells tools at a discount price. After all, Harbor Freight Tools has a turnover of 5 billion dollars. Other CLO borrowers include AppLovin, a company that markets advertising online. Or Anastasia Beverly Hills, a provider of beauty products.
The tenor of the Bloomberg story is that the financiers are pushing their way through CLO lending. The first winner in this game is Eric Smidt, the head of Harbor Freight Tools. According to Bloomberg, he owns a super yacht as well as a pretty estate in Beverly Hills filled with works of art. According to Bloomberg, the various loan fees of the structured loans for syndicate banks, CLO distributors and rating agencies amounted to around 10 billion dollars last year.
A gigantic and intransparent market
Buyers of such CLOs are investors looking for a seemingly safe investment with a relatively high yield in a zero interest rate environment. As a structured loan with a regular interest payment, a CLO is also interesting for all investors who rely on reliable distributions such as pension funds or insurance companies. The magazine “Forbes” quotes the Bank of England in an article from June 2019, according to which the value of the CLO market worldwide amounts to around 750 billion dollars. A third of this is in the balance sheets of banks in the USA, Europe and Japan. However, this data comes from the end of 2017. It is unclear who exactly currently owns these three-quarters of a trillion dollars. So “Forbes” could locate only a small part of the owners.
US banks, for example, hold around 87 billion dollars in CLOs, 81 percent of which are held by Wells Fargo, Citibank and JP Morgan. In March 2018, four Japanese banks had CLOs worth 108 billion dollars; the lion’s share, 68 billion dollars, was held by Norinchukin Bank, while other buyers were Japan Post Bank, Mizuho and Sumitomo. Forbes” continues: “The California Public Employees Retirement System (Calpers) with 6.7 billion dollars is the largest holder among the non-banks. This is followed by the New York State and Local Retirement System with a good 3 billion US dollars. In addition, US insurers had purchased around 51 billion dollars from CLO by the end of 2017. Around 9 percent of the CLO value is held by various funds worldwide.
Risk of contagion in the event of a wave of bankruptcies
The problem is that if a recession strikes, many borrowers could topple over at once. And the alleged collateral would then be worthless. What would hit the buyers of the CLO. And what the financial industry likes to override. According to Guggenheim Investment’s full-bodied self-advertising, the bulk of the collaterals packaged in the CLOs consist of first-rate bank loans, so they are serviced first if the company tips over. However, there is also a small proportion of second-rank loans and unsecured loans.
The next “big short”?
Our conclusion: the whole thing is indeed a striking reminder of the financial crisis of 2008. A good decade ago, the danger came from supposedly high-quality synthetic bonds backed by junk mortgages. Buyers of these high-risk investments were mainly pension funds and unsuspecting commercial and investment banks such as WestLB, Bear Stearns and Lehman Brothers. They stood at the end of the chain and burned their fingers with the thrown hot potato. Only a few clever investors saw through the nasty game and bet against the naive buyers. All this can be read in the book “The Big Short” by Michael Lewis.
Now it’s CLO. On the one hand, the risks now lie in a rising interest rate, which makes corporate loans more expensive. And on the other hand, in a recession in which loans could burst and creditors could topple by the dozen in the wake of a massive default. Which is likely to result in a chain reaction in the CLO market. A crash in global trade seems quite possible due to the global dispersion of CLOs and uncertainty about who exactly bought the bonds. Investors should therefore be vigilant here. And CFD traders should also keep an eye on the issue – fortunately they can hedge against risks with Germany’s best CFD brokers with a Bafin licence via short engagements.
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