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CLOs Threatening to Break, as Credit Downgrades Continue

Chris Gaetano
Published Date:
Apr 20, 2020
The $600 billion market for collateralized loan obligations (CLOs) is threatening to come apart, as the risky loans that they're packed with face a wave of credit downgrades, according to Bloomberg.

A CLO is very much like the well-known collateralized mortage obligation (CMO) that made headlines during the financial crisis, but instead of being stuffed with home loans, it's filled with business loans. As a way to head off the risks that ultimately doomed CMOs during the 2008 crisis, these CLOs generally have rules forbidding them from bundling loans below a certain credit threshold, and if a borrower's rating falls below it, then the CLO must eject that borrower, thus ensuring the asset's credit quality.

The problem, said Bloomberg, is that the CLOs were not built to account for the widespread credit downgrades we have been seeing over the past few weeks. As a result, the very rules meant to protect CLO holders may wind up bringing ontheir doom. Bloomberg said that there are growing risks that, because of mass downgrades, firms that manage the CLOs will be forced to sell underperforming loans at severe discounts or else suspend cash payments to investors while they hope to recover. Some analysts estimate that as many as one-third of CLOs may suffer this fate over the coming months. The CLOs themselves  might be considered a higher credit risk, too, as Moody's warned that it may  downgrade as many as 859 CLO securities, nearly a fifth of all such bonds that it grades.

While the Federal Reserve earlier announced that it would allow CLOs to be used as loan collateral, the central bank is only accepting static CLOs rather than managed ones. The difference between the two is that in a static CLO, the collateral or referenced entity is known and fixed through the life of the asset, which lets investors assess tranches with full knowledge of what the collateral will be. In contrast, a managed CLO has someone behind it actively making deals.

CLOs might not be the only loan-backed security with these kinds of problems. The Wall Street Journal said that China's market for bonds backed by debt instruments such as car loans and mortgages, is threatening to crack, as the number of past-due loans backing such bonds has hit record highs, meaning that if issuers cannot make up for the losses soon, bondholders will lose money as borrowers default. The Journal noted this could be a dire omen for the United States as well, because Americans tend to borrow more than the Chinese.

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