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COVID-19, Economic Crisis Put Pressure on CLOs

Kenneth Duvall & Philip R. Stein

As state and local governments throughout the country attempt to find a balance between re-opening the economy and sheltering in place, fears persist that the COVID-19 pandemic has already set in motion the next financial crisis. Early in the pandemic, we wrote about various types of debt that might melt down because of increased borrower defaults, including securities backed by student loans, auto loans, and commercial mortgages.[1]

Of all the debt instruments that we wrote about, perhaps the most dangerous remains corporate debt.[2]In March, we described the mushrooming scale of corporate debt over the last decade.[3] Many analysts are now focused on not only the size of corporate debt but also its structure.[4] Residential mortgage loans before 2008 were often pooled into securitized trusts called collateralized debt obligations, or CDOs. Similarly, corporate debt is now often pooled into securitized deals called collateralized loan obligations, or CLOs. CLOs contain corporate debt of varying quality, and concerns are growing about just how poor quality some of the corporate debt may be.

Those concerns mount when one considers how much exposure some of the country’s largest banks have in this type of transaction. Wells Fargo holds $34.6 billion in CLOs, while JPMorgan & Co. holds $20.5 billion and Citigroup Inc. $18.1 billion. [5]

Like CDOs, CLOs are arranged in tiers, so that the cash flow from borrowers’ payments goes to the highest-grade bondholders first, then the next highest-grade, and so on down the line.[6]  In good times, the lower tiers can experience tremendous returns. [7] But in bad times, those tiers are the first to experience losses. And if times become bad enough, the pain can start reaching up into higher tiers.

Various CLO funds (equity and bond) are reporting massive downturns this year.[8] In April, Moody’s put nearly a fifth of all CLO bonds that it grades on a watch list for downgrades.[9]  And even some of the highest-grade tiers—vaunted AAA/AA tranches—reportedly failed tests for asset coverage performed by Bank of America.[10]  Some analysts think that not only junk tranches, but even investment-quality grades—BBB, if not higher grades—could suffer losses in CLOs in coming months and years.[11]

Other analysts believe that concern about CLOs is currently overblown because the rates of default remain relatively low.[12] Then again, most analysts were taken by surprise with the speed and scale of the collapse of CDOs during the last financial crisis.


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