The Attention Span of Mayflies

The memory and attention span of financial market participants can be compared to that of mayflies. The mayfly is a member of the order ephemeroptera, from the Greek term for 'short-lived' (literally: 'lasting a day'). The English word 'ephemeral' comes from the same root. You get our drift.

Not long after yesterday's post about the growing signs of unbridled speculation in credit markets was published, we came across an article in the WSJ, entitled “Borrowing Cash to Buy Complex Assets Is In Vogue Again”. We're not particularly surprised to come across such an article, but this is definitely an interesting addendum to yesterday's missive.

The topic are collateralized loan obligations, or CLOs for short. As the WSJ informs us, CLOs were among the structured credit products that held up comparatively well in the 2008 crisis, with not too many defaults occurring in their component loans. What's contained in a CLO? “CLOs are bonds typically backed by pools of low-rated corporate loans”, the WSJ informs us. Many CLOs are nevertheless sporting triple A ratings, either due to overcollateralization or due to being sliced into tranches of different seniority. Banks still hold quite a few of these securities, but they want, or rather have to, get rid of at least some of these holdings:

“Many banks own CLOs themselves, holding about $130 billion on their books. New regulations may mean some banks will be forced to sell some CLOs in the next few years.

Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.

Banks "are resorting to creating economic incentives to get primarily hedge funds to step into this void," said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs.”

What 'economic incentives' might these be? Banks are trying to entice hedge funds to buy CLOs by offering them credit to buy them. We learn that hedge funds have once again 'come to embrace' leverage. In fact, buying CLOs without employing leverage is just not worth it. But there are evidently risks…

“Using borrowed money to buy securities may help hedge funds bolster returns, a useful strategy with interest rates at rock-bottom levels on many other mainstream debt investments.

Many investors steered clear of borrowed money after getting burned in the financial crisis, when they were forced to repay loans on securities whose value had fallen. But several investors said CLO returns wouldn't be attractive now without leverage.

Hedge funds "have finally come to grips with leverage and begun to embrace it" for CLOs, said Jean de Lavalette, head of securitized products sales at Société Générale.

But with leverage comes risk. Even a small drop in the market could force investors to pledge more cash and other collateral to offset the securities' decline. Losses are magnified when borrowed money is used.”

It sounds like courting disaster to us.

Cosmetic Differences

So what kind of leverage are we actually talking about?

“Overall, borrowed money is mostly being used to buy triple-A-rated CLOs, say bankers and investors. That contrasts with the run-up to the 2008 crisis, when huge sums were borrowed to finance bets on assets such as subprime mortgages.

[…]

CLOs performed better in the financial crisis than other esoteric offerings, such as collateralized debt obligations, backed by subprime mortgages. CDO investors suffered heavy losses following rating downgrades and defaults in the crisis, while CLOs were more resilient and suffered comparatively few defaults.

[…]

Banks have offered to lend some investors as much as $9 for every dollar that the buyers invest in CLOs, say traders and strategists. Others are being offered $8 for every $2.

An investor in a triple-A-rated CLO earning 1.50 percentage point over the London interbank offered rate—using 10% of his or her own money and paying 0.80 percentage point over Libor for the financing—could earn about 8% in a year.

That compares with annual interest rates near 2% on a standard triple-A CLO. Citigroup researchers in a mid-April note to clients predicted that the new source of financing could help drive up prices of triple-A-rated CLOs.”

Good grief. We will comment on this point by point.

There is actually no 'contrast' with the run-up to the 2008 crisis; the difference is merely cosmetic. Many of the CDOs and other structured mortgage finance products that lost up to 97% of their value in the worst cases were also 'triple A rated' just prior to the crisis. They were rated so highly because of the way they were structured, which made it appear highly unlikely that senior tranches would ever suffer losses.

Whether overcollateralization or the slicing into tranches of different seniority are employed, both achieve the same effect: it becomes possible to give a higher rating to dodgy debt, on the grounds that 'historically, only a certain small percentage has defaulted even in worst case scenarios'. This is precisely the reasoning that was used by rating agencies in the structured mortgage credit markets prior to the 2008 crisis. The main reason why CLOs fared better than mortgage backed credit instruments in the crisis was that the crisis was concentrated in real estate and mortgage credit. The next crisis will be concentrated in a different area. Most likely it will be corporate debt. Again, there is no 'contrast'.

The Risks are Many …

So leverage of up to $9 for every dollar invested is offered, which will produce  a return of 8% per year. If the next crisis does indeed focus on corporate debt, there may well be single trading days when 8% are lost in such instruments – without taking leverage into consideration, mind. One must not forget that during financial panics, sell orders are given first and questions are asked later. What will the liquidity in these structured products be under such circumstances? We can tell you already: all bids will simply disappear. Note that due to new regulations that are supposed to make the system 'safer' (ha!), banks are no longer the big traders in corporate bonds they once were. There are no longer any big market makers to fall back on in times of stress.

Citigroup is correct: while hedge funds are levering up, prices will rise. In all likelihood these securities are already overpriced – in fact, it is absolutely certain that they are, as money printing has distorted interest rates and consequently the prices of financial assets as well. Speaking of interest rates: obviously, default risk is not the only risk associated with these securities. There is interest rate risk as well. If rates rise, two things will happen: the borrowings that support holding  such securities on margin will become more expensive, while the prices of the securities will fall at the same time. Anyone borrowing $9 for every dollar invested will be in a very uncomfortable position if that happens.

One may be tempted to say 'so what'? After all, hedge funds will never be bailed out by tax payers. However, one must not overlook the fact that the banks are not insulated against the risks these trades entail, since they are lending the money. In other words, they are only altering the composition of their risk exposure, but the risks remain the same, or may even turn out to be greater (depending on the speed and size of the coming denouement). This is aside from the fact that in the event of large players in the financial markets running into trouble, risk contagion in general cannot be avoided. One only needs to recall LTCM, a large credit hedge fund that keeled over in the Russian crisis (it was specialized in convergence trades, betting that credit spreads would decline, and reportedly employing huge leverage). The Fed forced large investment banks to put together a bail-out package for the listing fund, as it was fearing that otherwise systemic risks would snowball.

From the Wall Street Journal: CLO issuance is 'roaring back' – click to enlarge.

Lastly, the WSJ notes:

“CLO prices have begun to recover, and CLO issuance has picked up after a slow start to the year. More than $35 billion of CLOs were created so far in 2014, the most for that period since 2007, when $36.4 billion were created, according to S&P Capital IQ Leveraged Commentary & Data.”

This is not surprising, but it isn't particularly comforting.

Conclusion:

Don't get us wrong – we have nothing against financial innovation. There will always be new financial products created to satisfy investor demand, and to optimize the intermediation of credit and risk. The problem is the monetary system itself, in short, the foundation on which all these activities rest. Since the 2008 crisis, the US broad true money supply has soared from $5.3 trillion to more than $10 trillion, and commercial banks haven't even increased their inflationary lending much as of yet. In the process, prices and risk perceptions have once again become extremely distorted. When fund managers begin to employ 10:1 leverage to obtain an 8% annual return and banks are eager to provide the necessary credit, it is simply yet another symptom of bubble conditions.