A trip down memory lane: the metamorphosis of CDOs into CLOs

What follows is a series of events that should make us reflect, a set of events that we should have learned from and that we seem to have forgotten about today. A review of different moments in the last decade that hopefully will help many to be aware of a possible reality in which 12 years ago we did not come out successfully.

Many of us will remember 2008 and the years that followed as years when financial jargon and its complex concepts, until then unknown to many, flooded the press and brought negative consequences to our lives, still present to date.

In this whole ocean of concepts, operations and financial products, we want to shed some light to the CDOs (Collateralized Debt Obligation), one of the main products that helped trigger the 2008 financial crisis.

CDOs are debt securities (a securitized product) backed by another set of debts; that is, the future of the latter depends directly on the result of a collection of cash flows from debts that have a different risk. A structured financial product, backed by a set of loans and other assets that is sold to institutional investors, such as insurance companies, investment banks, hedge funds, etc. Another interesting point to consider is that CDOs are a type of derivative, since its name indicates, the value is derived from and depends upon another underlying asset, i.e. other debts that become the guarantee if the loan is not repaid.

In order to create a CDO, banks gather assets that generate cash flows, mainly mortgages, consumer credits — like mortgages, bonds and other types of debt- and regroup them in classes or tranches based on the level of credit risk, that is, according to their default risk, which is difficult to determine due to their diversified composition. The idea is that the institutional investor invests his money in a financial product with a high return, with, apparently, little risk. In fact, the chef Anthony Bourdain explains and compares the CDOs in the film The Big Short as a seafood soup cooked with shrimp, lobster and fish from three days ago.

In the years leading up to 2008, banks increased their marketing of CDOs to investors for several reasons: selling the instrument transferred the risk from the bank to the buying institutional investor, while providing liquidity to the bank so it could grant new, higher-risk mortgages, knowing that the bank would not keep the assets, and that granting more mortgages meant higher returns for the employees granting the products.

The increased risk brought greater profitability, increasing the price of the product that was subsequently sold to the investor, as well as the banks’ profits.

During the years before the financial crisis, the CDO market saw its value increased almost tenfold, from $30 billion in 2003 to $225 billion in 2006.

But let’s go a step further: apart from the products previously explained we must add the so-called synthetic CDOs, another title or product whose price and result depended directly on a CDO. Buying a synthetic CDO was like betting on the outcome of another CDO. Let’s imagine the synthetic CDOs as a long tail behind a CDO, in which each person is betting on the probability of non-payment or default of the product (the synthetic CDO) of the person in front, betting on the outcome of the bet in front… Now change the people for institutional investors and you will get a scenario similar to that of March 2008, where institutional investors bet on these financial products because they believed the real estate values would be on the rise permanently.

To put it in perspective, a collection of credits packaged in a CDO for a value of 5 million Euros could have 5,000 million behind it depending on its result and in the hands of different investors. It goes without saying that until 2008, these investors who bought the synthetic CDOs were the same ones who kept our savings, took care of our payroll and prepared our 401(k).

We leave the theory aside for now and return to that timeline we intended to follow.

In early 2007, Wall Street began to witness the first symptoms of the CDO bubble. Defaults were rising in the mortgage market, and many CDOs included derivatives that were built on mortgages. Major institutional investors such as commercial and investment banks and pension funds began to see the value of these derivatives decline, directly impacting their balance sheets.

As soon as the first credits were defaulted, the CDOs lost their value, the system collapsed and “the crisis” came into realization, and with it Spain collapsed: the IBEX dropped by 40%, the default rate in construction reached 30% and unemployment reached 26% in 2013.

Moving forward in our timeline, we situate ourselves in the spring of 2019, when the Bank of Spain publishes El crédito apalancado al sector de grandes empresas, a discreet 4-page article that few (2) media outlets decided to cover. This publication warned of the notable increase in CLOs in the European and global economy: “CLO emissions in Europe have tripled from 2013 to 2018”. Both the publication by the Banco de España and the subsequent mention in the press further observed that “Spain shows a clear upward pattern”. As does the United States:

However, to understand more precisely the reason for the existence and implications of CLOs, we must first present a clear definition of Leverage Buyouts or LBOs.

When a company wants to buy another company it usually uses leverage to make the purchase, hence the company goes to a financial entity to ask for a loan to be able to buy the targeted company. The buyer now has an additional company that also generates revenue, which it will use to repay the loan to the lender until the loan expires, from then on it can keep what the new acquisition generates. Easy and attractive as long as the acquired entity generates the forecasted cash flows to pay back the loan.

The bank then collects different loans to companies, unifies them into a single product, labels it as a CLO and sells it to a third party so that the company becomes obligated to the buyer of this CLO.

In 2007, Reuters already reported the increase in synthetic CLOs in Europe; the first trench of investors were beginning to form, who were now betting on loans to companies (synthetic CLOs). Leaving aside the similarity in the names of both financial products, this situation clearly reminds us of CDOs, but now, instead of having a collection of credits to individuals we have a collection of credits to companies, which have been used mostly to buy other companies. That may result in default in the event that they are not able to meet the interest payments with their recurrent cash flows.

This situation should already have made you a little nervous, because as the Bank of Spain mentioned, these titles do not seem to have any risk until the company that has to invoice to pay the loan stops doing so. Even more problematic is if it is not just one company that cannot pay and it is a whole sector, area or industry (as could be, hypothetically and in a totally illustrative case, the airline industry).

This type of asset should not raise our concern in times of prosperity or growth since they helping hundreds of companies to grow, and with them, the economy. Now, of course, there is the risk associated with these operations, a risk that lies in the state of a country’s economy and in the consumption and spending capacity of a population, which clearly seems to be in a critical and questionable situation now.

We cannot end without mentioning the fundamental role of rating agencies, entities whose function is to qualify different financial products according to their risk and which were highly questioned and punished after the 2008 crisis for labeling CDO’s seafood soup with fish that has gone bad as “a delicious shrimp and lobster soup”. The rating agencies now have a fundamental role again and are in the spotlight to qualify and unqualify the collections of debts to companies or CLOs, since an accreditation given 4 years ago cannot be the same given the current state of the economy. The probability of default today of a medium-sized airline cannot be the same as in 2018, and so should reflect the rating corresponding to the CLO containing such obligations.

This risk is what columnists, editors and analysts like Joe Renninson are beginning to question in media such as the Financial Times. However, it seems to be a topic that attracts few clicks in the most popular press or in the newspapers we usually read while having breakfast, and therefore, those who read them do not seem to be interested, or the complexity of such instruments overwhelms them. That is why we have tried, in much simpler words, and with more illustrative examples, to present the scenario we are currently in.

With a simple Google search we will find different articles listing the differences between CDOs and CLOs as well as the reasons why the situation today is very different from that of 2008. But we must also point out that the risk associated with the CLO market is worth $600bn today, with common features and very similar to the CDO market that exploded in 2008 when it reached a volume of $700bn.

We share this short article moved by curiosity, eagerness to learn, and as far as possible, learn from the situation so that we can act on it and avoid what we once could not.