Market Watch: Why a Bomb Like the One that Blew up Markets in 2008 May be Ticking Right Now

March 04, 2019

Article by Shawn Langlois in Wall Street Journal Market Watch

It’s been a banner year for stocks already. In fact, if we could just shut this whole thing down for the next 10 months, we’d be looking at double-digits returns on the S&P 500 for 2019. No complaints with that kind of annual performance.

Alas, it doesn’t work that way, and, needless to say, there are plenty of things that could go sideways before the bell rings in 2020. One of the risks could come from a familiar source: leveraged loans.

Satyajit Das, a former banker who was once hailed as one of the world’s 50 most influential financial figures, says we could be facing a bomb similar to the one that exploded in the market a decade a year ago.

“Financial markets have short memories,” Das wrote in an opinion piece for Bloomberg over the weekend. “Of late, they’ve convinced themselves that collateralized loan obligations (CLOs) are much safer instruments than the collateralized debt obligations, or CDOs, on which they’re based and which helped precipitate the 2008 crisis. They’re wrong — and dangerously so.”

CLOs are similar to CDOs, in that each pools multiple loans to create synthetic, bond-like investments. It’s wonky stuff, but, basically, CLOs are set up to be a safer way to increase the leverage on a portfolio of debt. Instead of mortgages, subprime and otherwise, in CDOs, CLOs repackage corporate loans, and consumer credit, such as car loans.

Nevertheless, many risks remain,” Das warned. “How safe or not CLOs are is contingent on several factors: the credit quality of the underlying loans — as judged by the risk of default and the extent of loss if there is a default — as well as the correlation between default and losses within the portfolio.”

There’s currently $700 billion in outstanding CLOs around the world right now, with annual new issues of more than $100 billion, similar to what we saw in the infamous subprime CDOs in 2008.

Das said many aspects of the risks aren’t fully understood. For instance, the credit quality of loans packaged in most CLOs is below investment grade and the borrowers are highly leveraged, which increase the risk of higher losses.

“Investors assume that the portfolios are safer because they’re diversified,” he wrote. “Yet, relative to mortgages, corporate-loan portfolios typically are made up of fewer and larger loans, which increases concentration risk. Leveraged loans are highly sensitive to economic conditions and defaults may be correlated, with many loans experiencing problems simultaneously.”

As we’ve seen before, the nasty unwind can spiral out of control at warp speed in the face of a downturn.

“The risk is that CLOs will create adverse feedback loops,” Das said. “Falling prices, rising spreads and tightening credit availability will cause credit markets to seize up. Tighter credit will feed into the real economy, setting off losses, selling and price declines.” That’s when the fear contagion kicks in, he continued, as the financial position of banks is questioned and depositors refuse to fund banks.

There are too many parallels to 2008 for comfort. Investors, many with uncertain expertise and weak holding power, have increased their exposure in the search for higher returns,” Das warned in his op-ed. “Built into this speculative episode, like its predecessors, is a euphoric flight from reality and a blindness to risks that continue to rise.”

To read this article in Wall Street Journal Market Watch, click here.

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