Here’s Why I Haven’t Been Sleeping Well Lately: A Thread on Derivatives.

CLOs, or Collateralized Loan Obligations. Sound familiar? That’s because they sound like CDOs from 2008.

As a former derivatives trader, I am watching something worrisome everyone needs to understand.

First: CLOs are securities backed by loans, each with varying tranches. The tranches are ranked by quality of loan: investment grade, unrated, and speculative.

Once the loans are packaged, the CLOs get another rating, based on bonds attached to them & the rates of the bonds.

The CLOs then get artificially rated higher than their underlying loans because of the reclassification from being repackaged... hiding potential crap that may be sitting inside of them.

Who holds the CLOs? Firms that need securities: banks, insurance companies hedge funds.

So what did CLOs do in 2008?

Not a ton, because higher-rated tranches were OK. But don’t mix up CLOs with CDOs(Credit Default Obligations) and CDSs(Credit Default Swaps). These were the bad guys in ‘08. However, CLOs are essentially hybrid CDSs and CDOs. https://abs.twimg.com/emoji/v2/... draggable="false" alt="🙃" title="Upside-down face" aria-label="Emoji: Upside-down face">

So what’s the big deal? Moody’s downgraded 20% of the underlying loans in the CLOs at the end of April, & put $44 billion additional on watch for further downgrade. This could end up downgrading the CLOs, which in turn could grade them as junk (40% are currently investment grade)

Looking deeper, Fitch ratings anticipates $80 billion (15% of the CLO market) to default. To compare, in 2009 they stated $78 billion would fail. 14% of these CLOs are due by the end of the year, with a total 35% due by 2021.

Let’s go back to 2007: the CDO market (re: CLO’s sister from The Great Recession) was $640 billion. Today, the CLO market is $1.4 trillion.

To translate, that means *much* more room for defaults across the board.

So tying this back to why I care: Where are the CLOs created? Debt from companies with less-than-perfect credit: airlines, hotels, restaurants, and entertainment are currently the most troubled CLOs.

Here’s what could happen:

Companies go bankrupthttps://abs.twimg.com/emoji/v2/... draggable="false" alt="➡️" title="Rightwards arrow" aria-label="Emoji: Rightwards arrow">Lenders will be unpaid due to poorly-written covenantshttps://abs.twimg.com/emoji/v2/... draggable="false" alt="➡️" title="Rightwards arrow" aria-label="Emoji: Rightwards arrow">Loans in the CLOs begin to downgradehttps://abs.twimg.com/emoji/v2/... draggable="false" alt="➡️" title="Rightwards arrow" aria-label="Emoji: Rightwards arrow">CLOs get rated junkhttps://abs.twimg.com/emoji/v2/... draggable="false" alt="➡️" title="Rightwards arrow" aria-label="Emoji: Rightwards arrow">The $1.4 trillion market becomes illiquidhttps://abs.twimg.com/emoji/v2/... draggable="false" alt="➡️" title="Rightwards arrow" aria-label="Emoji: Rightwards arrow">Market crashes

I will be watching the CLO market in May & June, as I really believe this quarter will determine the extent of the damage. We already see a lot of companies filing for bankruptcy, it’s just a matter of how the government works to contain the damage and keep markets liquid.

It’s not as easy as saying these defaults will automatically cause a crash. CLOs have risk that is attached to the bonds which price them. Since bondholders take the default risk on these, and banks tend to be the sellers... there’s a lot of opacity to the overall market damage

I envision lots of money spent on saving the insurers of the CLOs in addition to big banks needing yet another bailout... sounds familiar, right?