More than 10 years after collateralized debt obligations (CDOs) played a big role in the 2008 recession, a different side to the same coin has investors in the United States and beyond concerned about the possibility of another imminent downturn in economic activity: Meet collateralized loan obligations (CLOs).
A form of CDOs, CLOs are a classification of loans that was created with the aim of facilitating profitable transactions for conservative and risk-chasing financial institutions alike. In a nutshell, a CLO is built around a tranche system whereby multiple loans are combined together. The loan payments are not distributed equally among a CLO’s owners. The various owners are rather bundled into tranches, with classes entitled to the highest interest rates being those taking on the highest risks in case of a failure to repay. In this sense, CLOs satisfy the needs of all types of investors, all while allowing banks to more easily sell loans to external lenders and stimulating markets at times of tepid investment activity.
CLOs have been a part of the US market since the early 1980s, but naturally went through a rough trough in the aftermath of the 2008 recession. Their rate of usage has gradually picked up since then, with 2018 being a particular boom year for these once-marginal investments as, per Bloomberg, fees linked to the industry topped $10 billion. As of December 2018, the amount of outstanding CLOs in the U.S. market totaled nearly $600 billion.
Morgan Stanley, Ares Management, and Bill and Melinda Gates are some of the investors involved with the recent uptick in CLO transactions. Proponents of the loans point out that their top-rated segments have never defaulted even in the midst of financial downturns. Moreover, CLOs’ floating rates among their different tranches are said to shield investors from steep losses, making them a worthwhile complement to more traditional investments in wholesome portfolios.
Critics of the investment form, on the other hand, note that it is problematic when borrowers have the upper hand vis-à-vis buyers. Another troublesome layer is that CLOs typically have more than 100 issuers bundled into one product, thereby making documentation difficult and presenting avenues for investors to become unknowingly attached to problematic loans. A further concern is that the frenetic rate of sales is bringing about reckless behavior at a time when the global financial sector has yet to fully recover from the 2008 recession. Indeed, financial behemoths such as the Bank of England and Fitch Ratings have warned investors of the risks associated with CLOs, ones that can potentially lead to increasingly volatile market conditions on the long run.
There is no telling whether these concerns will ultimately ring true or not. The top-rated tranches of CLOs appear properly insulated from danger. Others, though, carry with them a high degree of risk for the entire global economy. One can only hope that the bets are not entirely off from here on out.