August 19, 2020 - As loan market participants, we have all seen our share of news stories that make our eyes roll over the misunderstanding of CLOs and the role they play in our financial system. But we are now starting to see some building momentum for data, facts and astute analysis to counter those false views.
Recently two professors of finance at the Wharton School of the University of Pennsylvania, Michael R. Roberts and Michael Schwert, published Why CLOs Will Not Cause the Next Financial Crisis in knowledge@Wharton, the online business analysis journal at the school. Roberts and Schwert stated, as the LSTA has, that if bank holdings in CLO investments defaulted, this would pose no systemic problem for the U.S. banking system. The professors note that only a few large banks hold a relatively small portion of Tier 1 capital in CLO investments and nearly all of that in low risk AAA-rated tranches. They concluded that “[i]f every loan in every CLO defaulted at the same time, and all the assets securing those loans evaporated into thin air so that the lender couldn’t recover any money, these three banks [ JP Morgan, Wells Fargo and Citi] would still be left with over 80% of their equity capital, or more than $400 billion.”
We made a similar analysis with the same conclusions in the last issue of Loans Magazine. It remains a puzzle why many continue to conflate CLOs with the similarly sounding CDOs of another era and the last financial crisis. While there may be reasons for concern around business lending and the level of financial leverage, particularly during the COVID-19 pandemic, misunderstanding and misreporting of CLOs and the potential impact they may have is irresponsible. Whether we look back in time to historic performance or project a pessimistic future for our economy, CLOs are constructed, to hold up, protecting the top of a “layer-cake” capital structure from suffering credit loss. We made the point in our piece in Loans Magazine that even if the CLOs experience a greater percentage of defaults and worse recoveries, given default, than during the Great Financial Crisis of 2009, the banking system will not experience severe problems.
There have been many similar articles relying on hard data and the Knowledge@Wharton piece is the latest to critically examine this issue and to conclude that the notion that CLOs are analogous to CDOs of 2008, and therefore will be the cause of our next financial crisis, simply does not comport with the facts. In this matter, it is important to remember the astronomer Carl Sagan, who once said, “For me, it is better to grasp the Universe as it really is than to persist in delusion, however satisfying and reassuring.”
By LSTA Executive Director Lee Shaiman