The Sequel to the Global Financial Crisis Is Not the CLO! (Ok, Not Yet)

by Dechert LLP

Last week, an article written by Mr. Frank Partnoy, professor of law at the University of San Diego,  appeared in the Financial Times and was subsequently picked up by The Wall Street Journal.  Mr. Partnoy argues that the next global financial crisis will be found inside the CLO industry and that past is prologue.

I think he is looking under the wrong rock for the next global financial crisis and this note should serve as a letter to the editor in rebuttal, as it were.  (Perhaps I’ll send Professor Partnoy his own personalized copy.)

Here’s the news flash:  There will be another global financial crisis.  Death, taxes, the cycle and Page Six misbehavior will never go away.  However, history suggests that the next one will be less severe than the 2007-2009 meltdown which, one can hope will continue to be entitled to the honorific “The Great Recession” for many decades to come. 

The ticking time bomb is not in the CLO industry.  To be sure, when the next financial riptide happens, loan defaults will accelerate and losses will be incurred across portfolios and in structured finance vehicles as well.  Sort of syllogistic, isn’t it?  Recessions mean diminished financial results, diminished financial results cause loans to default.  Loan defaults will cause things that hold loans to suffer stress.  That’s hardly above-the-fold news.  But the suggestion that somehow, capital formation occurring in the non-bank sector (which is what the CLO space really is) will be the epicenter of the next disaster is wrong-headed.  Generals fighting the last war.  Maginot Line stuff.

When I look back on the late unpleasantness (as they might say down South) and look at all the suspects in the police lineup after that crime scene, the dodgiest of the dodgy was clearly the subprime and Alt-A residential lending complex.  It mattered not, whether this product was housed in structured finance or in portfolios or in the government guaranteed space.  If you owned a bucket of no-doc residential loans, they tanked, whether as whole loans or as bonds.

OK, the meth lab science that wove IG bonds out of this crap was a breathtaking failure and in some measure made the problem worse (or perhaps really just the spread the problem to an investor group that didn’t think it was at risk), but the basic assumptions behind the development of this technology was received wisdom across almost all participants in the mortgage finance space:  bankers, rating agencies, research departments and investors.

That business is cold and dead but the indictment in Prof. Partnoy’s letter was broader.  The indictment was that it was the securitization technology itself that was a primary cause of the great recession and remains the incubator of the next.

The CLOs of the non-bank sector were not a principal villain of The Great Recession.  They played but a bit part.  Indeed, the problematic structures at the time were overwhelmingly the multi-sector residential mortgage CDOs, synthetic CDOs and other multi-sector CDOs.  Cash CLOs actually performed rather well across the crisis years.

I am not arguing that non-resi CDOs didn’t fail; some did, and in some sectors, some failed spectacularly.  Indeed, those failures were particularly shocking for the investment grade gang who embraced the magical thinking that structure beats economics. Wrapped protectively in their investment grade ratings, they apparently thought they could watch the chaos around them with equanimity.  Perhaps if the cold winds of common sense had blown more strongly through the corridors of the investment world, more would have noticed that complex, multi-sector structured CDOs might not be the most robust ships to sail through the choppy waters of a major recession.

While true, it’s not particularly relevant to the argument that the post Great Recession CLOs house the seed of the next great crash.  The pre-crash transactions were incredibly complex and largely driven by cash flows in the sky and economic models severed from any real world perspective.  Formula One racing cars made of glass.  It was the mad scientist thing.  Toss in a little of this, toss in a little of that, grab a little herf here, a bit of extra yield over there, pull out the senior mezz and stuff in a junior class, fervently believe in your models and, hey, what’s really wrong with a synthetic bucket or two? Voila!  We ended up with multi-sector CDOs that were, in hindsight, doomed.

Those excesses and the structural features of the vehicles indeed amounted to an awful mistake.

But to conflate that with today’s business is simply not fair.  In the CLO space, including the CRE CLO, keep it simple stupid has been the mantra since the technology emerged from its bunker after The Great Recession.  The business does not pool high yield debt instruments and find investment grade paper only from the magic of diversity, scale and engineering.  It is strongly rooted in fundamental economic analytics and classic portfolio underwriting.  The CLO business is almost exclusively today the securitization of whole loans and the subordination levels remain extremely conservative.  On recent CRE CLOs, subordination of the AAA has been in excess of 40%.  The underlying loans largely have full covenants, recourse and structure which is highly coincident with any portfolio lender product and in some ways more rigorous than some.

Well, the old saying is that guns don’t kill people, people do and it’s always conceivable that a return to unreflective exuberance un-anchored from real world experience will once again cause us to turn the guns on ourselves so that CLOs become a credit risk to the marketplace as a whole.  But that’s not now, that’s not today, and hopefully, that’s not ever.

I know that the newspaper biz is a hard business, a business in which a serious and sober discussion of issues might take second place to lurid prose, but Prof. Partnoy’s indictment was not improved by florid and emotive turns of phrase such as the “flouting” of Dodd-Frank, the “frothing” shadow financial markets”, financial technology “culprits” and parties “dodging the law”.  That’s as yellow as yellow can get without a corpse or a ripped bodice.

Lessons were learned; hard lessons.  The scales have been removed from the eyes of market participants and they are remarkably clear-eyed today.  Ratings models are conservative, the regulatory state’s intrusion into capital formation for all its real, and sometimes ridiculous negative externalities, has heightened appreciation of risk and new rules such as risk retention and enhanced capital requirements have made capital formation safer.

The alternate banking market place which centrally includes the use of securitization technology is an important and necessary component to sustained capital formation and the growth of our economy.  The prudentially regulated banks are under enormous pressure which has had the consequence, intended or unintended, of suppressing lending, The Federal Reserve reported just this past week in its Senior Loan Officer Opinions Survey tightening in bank commercial lending, including real estate lending, across the board.  The regulators are continuing to beat the drums for reduction in CRE concentrations.  In part, reduced lending and reduced risk in the lending book is simply a reaction to the eco system around banking today and in part it’s a direct response to the increasingly intrusive regulatory state.  In any event, it’s real.

Therefore, it’s good we have the non-bank lending sector, maybe even essential.  One of the reasons that the US economy is more dynamic than many in the G20 is that our economy is not entirely dependent upon the banks for capital.  That’s a huge problem for Europe.

When risk is concentrated in the banking sector, making the banks a one-legged stool to support capital formation, capital becomes hostage to the health of the banks and to a host of regulatory and political issues particular to banking (think the doom loop of the unhealthy over investment (at zero capital charge) of European banks in European sovereigns).

So, the non-bank sector is important to the United States economy.  It’s a necessary part of the system, it’s a safety valve on risk concentration on the prudentially regulated banks, and all in, a very good thing.  Like any tool, the securitization technology can be misused but we use tools because they allow us to achieve our goals and this tool is being used in a prudent and reasonable way to help sustain our economy.

Now, if you really want to think about where systemic risk is, go turn over the rock under which the credit default swap complex lies and tell me if you can, Professor Partnoy, where all that risk ultimately lies.  Just saying.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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