History may not repeat itself, but some of its lessons are inescapable. One is that in the world of high and confident finance little is ever really new. The controlling fact is not the tendency to brilliant invention; the controlling fact is the shortness of the public memory, especially when it contends with a euphoric desire to forget. The rule is that financial operations do not lend themselves to innovation. What is currently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.  

–John Kenneth Galbraith, 1993

All eyes are focused on the markets, which take the temperature of collective investor sentiment every second and, in a more obtuse sense, of the economy, where news—GDP, consumer income and consumption, investment spending, net exports and the like—drips over the course of a month or months like water out of a leaky faucet.

Flying stealthily under the radar is a threat that could blindside market watchers and economic sleuths alike, potentially throwing the economy into a death spiral. Imagine waking up one morning to headlines bereft of the latest trends in the COVID-19 pandemic, the emergent global BLM (Black Lives Matter) movement, or divisive tweet storms from Donald Trump? What if the shocking news was that the financial sector was collapsing, with the nation’s largest banks at the epicenter?

“Impossible,” most would say. After all, the Financial Crisis and the lessons we learned from it are still fresh in our memories. Besides, in 2010 Congress passed the Dodd-Frank Act to prevent such a recurrence, and the Fed began “stress testing” the banks to ensure compliance.

Read no farther without returning to Galbraith’s words of wisdom above.

CDOs and ‘Tranche Warfare’

Few people have forgotten that the financial crisis was about home mortgages. Most, however, had no idea that the devil was buried in the prospectuses’ details, often 100–250 pages of almost undecipherable accounting and legalese. Hundreds of billions of dollars of home mortgages were packaged into securities known as collateralized debt obligations (CDOs). By selling their home loans to investment-banking firms who bundled (“securitized”) and resold them to all manner of institutional investors, local banks transferred what was traditionally their risk as the lender onto bigger banks and investors. Further, they collected a fee for doing so. One particularly perverse combination of incentives encouraged them to maximize the number of poor mortgages originated. Local banks were paid on volume, but fees also went up as the quality of the loan went down. From originators to securitizers to yield-hungry investors, subprime mortgages left everyone happy and yearning for more.

The CDOs were structured into tranches. These slices of the pool were ranked hierarchically by risk or other characteristics in order to be marketable to different types of institutional investors. The most senior-rated tranches had the highest credit ratings, and payments were made sequentially from the most senior to the most junior classes. The CDOs were contained an admixture of prime and subprime mortgages necessary to garner a AAA rating on the senior-most tranche(s). Moody’s and Standard & Poor’s reasoned that a systemic mortgage meltdown was unlikely because residential mortgages were spread all over the country, and defaults—often related to job loss, divorce, or poor health—were not correlated across markets.[1]

During the securitization heyday, default risk was an afterthought even though the complex nature of the CDO itself made that all the more probable under conditions of duress. “Tranche warfare” quickly became a melee of conflicting interests because no identifiable agent existed to serve as fiduciary. Before securitizations became the rage, on-site commercial and mortgage banks, exercising their best judgment, almost always preferred restructuring a loan with a borrower during a crisis rather than going to foreclosure. As the molehill of securitizations became a mountain, and so many loans were no longer in the hands of a portfolio lender but in a security for which nobody was directly responsible, the bubble burst.

The lightly regulated big investment banks and, to a lesser extent, commercial banks had to drink their own poison. In September 2008 Lehman Brothers was exposed as the poster child for fast-and-loose real estate speculation. Its risky holdings had progressively grown to 30 times its capital. Lehman’s losses originated from continuing to hold large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. With that kind of leverage, the firm’s return on equity was off the charts, but a 3–4% decline in the value of its assets would wipe out its equity. When things went south, that’s precisely what happened. It’s a matter of speculation whether it was greed that caused Lehman to keep such toxic waste on its books or if the company simply couldn’t find buyers at an acceptable price.

The S&P/Case-Shiller National Home Price Index (median price) was roughly $100,000 in January 2000. By March 2006 it had skyrocketed to $186,000. Analogous to what happened in the equity markets in recent years, it appears in retrospect that the spread of the extrapolation bug had reached epidemic proportions. As the securitization bubble popped, housing prices unexpectedly (but understandably for anyone who understood contagion) swooned to $136,000 by January 2012, six years later.[2] The value of the collateral on which the whole pyramid scheme depended, house prices, declined 27%. More than 13,000 AAA-related CDO investments defaulted during the crisis.

The Looming Threat to Bank Solvency

The latest iteration of financial alchemy if not chicanery is the virtually indistinguishable CDO knockoff, in both form and substance: the CLO (collateralized loan obligation). The reputation of mortgage-backed CDOs trashed, investors seeking higher rates found them in the CLOs. The product also served to scratch the low-interest-rate-induced corporate-credit itch late in the cycle. CLOs are bundles of so-called leveraged loans, the subprime mortgages of the corporate world. They are made to companies that have maxed out their borrowing, unable to sell bonds or qualify for traditional bank loans. Of the more than $1.2 trillion in leveraged loans outstanding, the majority are held by CLOs, which now total more than the entire junk-bond market.

According to the U.S. Financial Stability Board, 30 “global systemically important banks” had an average exposure to leveraged loans and CDOs equal to 60% of capital.[3] Like the coronavirus, it gets scary only if contagion sets in.

Perhaps tomorrow’s poster child will be the already much-maligned commercial bank, Wells Fargo. Buried deep in the bank’s latest 10-K in an asset category known as “available for sale,” $29.7 billion in CLOs were listed; and in a later filing an additional $7.7 billion worth of CLOs were tucked away elsewhere. Perhaps most vexing (and following a practice created by Enron years ago to park assets off the corporate balance sheet), Wells Fargo, along with other big banks, have formed similar structures called “variable interest entities” (VIE). Because reporting requirements are opaque, little is known—which is precisely why they exist. It’s estimated that Wells Fargo has more than $1 trillion in VIE assets, including questionable securities backed by commercial mortgages for shopping malls and office parks.[4] Meanwhile, the bank’s equity capital is $183 billion.

To be sure, the banks typically buy the CLOs’ AAA-related tranches. Like the sleight-of-hand with CDOs, examining the ingredients before they come out of the sausage grinder is not for the faint of heart. According to Fitch Ratings, two-thirds of the borrowers in its leveraged-loan database were B-rated, several notches below investment grade. The rating suggests a borrower’s ability (or inability) to repay a loan is likely to be impaired during adverse business conditions, precisely where we find ourselves today.

So, how does this subterfuge get swept under the rug? Such activities are rationalized via a risk-management scheme known as “default correlation”: the likelihood of loans defaulting at the same time. The rating agencies grade various tranches by looking at the individual leveraged loans and their default correlation, with the best ratings reserved for portfolios that are well-diversified across industry and geography. In a crisis, however, asset prices tend to become closely correlated. The CLO may not be as diversified as its creators expected.

The More Things Change, The More They Remain the Same

Though the CLO market is bigger than the subprime mortgage CDO market in its heyday, we have it on good authority that all is well since the risks from leveraged loans have been moved off the banks’ balance sheets and, at least in theory, outside the banking system. Fed Chairman Powell and Treasury Secretary Mnuchin argue that risk is contained within the CLOs themselves. See the cautionary tale of Wells Fargo above.

Like CDOs in 2007, today we are in the early stages of what could be a CLO-induced crisis. The FDIC-commissioned 57-page report, “The Subprime Credit Crisis of ’07,” was first published on September 12, 2007. The Lehman failure, marking the nadir of the financial crisis, was exactly 12 months farther down the slippery slope. As the current recession grinds on, it may expose new and unexpected fissures. In the months ahead we might discover that banks were hardly the only institutions to bet big on CLOs. U.S. life insurance companies average 20% of their capital committed to CLOs. Pension funds, mutual funds, and ETFs also are heavily invested in leveraged loans and CLOs.

Forewarned in 2007 about the ultimate financial and economic impact of CDOs—and realizing years later that the crisis was not cathartic—it seems unquestionably responsible to make every effort to be forearmed about the systemic risks that this latest incarnation of financial malfeasance poses.

[1] https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/

[2] Today the index stands at $215,600.

[3] https://www.fsb.org/wp-content/uploads/P191219.pdf

[4] Frank Portnoy, law professor at UC Berkeley, “The Worst Worst Case,” print edition of the July/August 2020 issue of The Atlantic. Portnoy’s resume is more than impressive. Still, like the fact checking we did during our research on master limited partnerships (MLPs) in 2014, we don’t consider our work on this matter closed.

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