A crisis the scale of the 2007/8 banking collapse required a dismantling of the intellectual, regulatory and financial networks at its core. When networks are not broken up, systems and behaviours tend to reproduce themselves. It was therefore no surprise when, soon after the crisis, securitization was again extended as the only viable solution to any number of economic problems, from the funding of SMEs to the rekindling of corporate investment. Handed a rare, fleeting moment of reconstructive possibility, our political classes and technocrats, in consultation with the banking lobby, chose to try to recreate 2006 – the pinnacle of the Goldilocks economy, forgetting the bear economy that followed.
There are strong indications that today’s economy may be entering the equivalent of its 2007/8 phase. A recent article in the Financial Times reports that the Financial Stability Board has launched a review of the leveraged loans market – a market which has boomed over the last five years in large part due to demand from collateralized loan obligations or ‘CLOs’. These securitization vehicles bear an uncanny resemblance to the Collateralized Debt Obligations (CDOs) that drove much demand for sub-prime mortgage backed securities before 2007.
A CLO has a pool of leveraged loans or similar low-grade securities which are its assets or ‘collateral’. Leveraged loans are like corporate ‘sub-prime’ loans – they are made to below investment grade companies, i.e. companies with a credit rating below BBB-/Baa3. This lending is financed by the sale of different tranches of securities which are the liabilities of the CLO. The investors who buy CLO securities are paid in a predetermined order – the holders of the lowest risk tranche (the AAA rated tranche) get paid first but receive the lowest rate of return; only after that point does the next tranche get paid and they receive a higher rate of return because they hold more risk, and so on. At the bottom of the waterfall structure is the ‘equity’ or ‘first loss’ tranche. The tranches receive interest and principal payments based on interests and other cash flows that the CLO collects from its pool of loans (Figure 1). CLOs work on the same alchemic principle as CDOs – the ability to convert trash into gold.
