The financial markets today are looking very much like they did a decade or so ago. And that can mean only one scary thing: Trouble is imminent.
Just as they did in much of 2007 and 2008, before the markets exploded in a crisis of epic proportions, investors in the debt market, which is even larger than the equity market, are feverishly chasing higher yields and are too eagerly buying up the risky securities that will deliver those yields without demanding the proper premium for the risks being taken. A decade ago, the high-yield investment du jour pushed by Wall Street was mortgage-backed securities — home mortgages that had been packaged up and sold as “safe” investments all over the world. Nowadays bankers and traders are pushing another form of supposedly “safe” investment, the “collateralized loan obligation,” or C.L.O.
C.L.O.s are nothing more than a package of risky corporate loans made to companies with less than stellar credit. The big Wall Street banks make these loans to their corporate clients and then seek to move them off their balance sheets as quickly as possible, in the same way that a decade ago they packaged up and offloaded risky mortgage securities. Just as with mortgage-backed securities, to move the loans out the door the banks have been counting on the nearly insatiable demand for higher yields — the combination of the price paid for a bond and the interest received — from investors who figure the risky loans will make them more than they could get by, say, investing in safer Treasury bonds. (A few percentage-point’s difference in the yield adds up to real money.)
This is not a tiny slice of the market. Of the trillions of dollars of corporate loans outstanding in the United States, roughly $1.2 trillion of them are considered “leveraged loans,” or loans to companies considered bigger credit risks. Some of those companies will not be able to handle the high level of debt they have taken on, and when they reach the breaking point, corporate bankruptcies will again begin to rise.
And those failures could be a serious concern, if smart people like Jerome Powell, the chairman of the Federal Reserve Board, are to be believed. In a speech before the Economic Club of New York in November, Mr. Powell said he thought that investors in C.L.O.s would bear the brunt of an uptick in corporate bankruptcies, rather than the big Wall Street banks. Those investors include Japanese banks as well as investors in hedge funds, mutual funds and pension funds (in other words, you and me).
Janet Yellen, Mr. Powell’s predecessor, aired the same concern in December, in a conversation with the Times columnist Paul Krugman. Ms. Yellen said she worried that corporate indebtedness was “quite high”: it’s now more than $9 trillion, up from $4.9 trillion, in 2006, according to the Securities Industry and Financial Markets Association. “I think a lot of the underwriting of that debt is weak,” she said. “I think investors hold it in packages like the subprime packages,” which became so popular before the 2008 crisis. “The same thing has happened. It’s called C.L.O.s, or collateralized loan obligations.”
Randal Quarles, who oversees Wall Street supervision and regulation at the Federal Reserve, also highlighted the looming systemic risk to the financial system, if and when C.L.O.s start getting hit by defaults. On the one hand, he told the Council on Foreign Relations in December, he takes comfort from the fact that Wall Street banks are offloading risky loans to investors — when they do, it moves that risk away from the heart of the financial system. But there might be a “backdoor” risk of exposure for banks, he said. That’s “something we need to be vigilant about,” he added, and it is something the Fed continues to analyze.
One backdoor risk is exacerbated by a tactic of some all-too-clever hedge fund managers. They buy a little of the debt of risky companies at a discount, and then buy a much larger amount of insurance on that debt — so-called “credit default swaps” — to theoretically hedge their risk. These wiseguys then do everything they can to force the company into a bankruptcy filing, which contractually triggers the insurance payoff on the debt. Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely.
The problem, of course, is that the bankruptcy filing can send the company and its creditors, including investors in C.L.O.s, into a downward spiral, hurting everyone but the architect of the scheme. That’s what happened to Windstream, an Arkansas-based telecom company that was sent into bankruptcy protection in February. These “empty creditors,” as Henry Hu, a professor of law at the University of Texas has dubbed them, are rewarded for pushing companies into an otherwise unnecessary bankruptcy. That’s not the way the markets are supposed to work.
After a brief moment of sanity in December, the loopy demand for high-risk debt has once again heated up. More than $13 billion of leveraged loans were sold in February, and they will soon worm their way into the financial markets as C.L.O.s. The existential question remains: Why do investors fail to learn the harsh lessons about risk, even though the consequences of them still remain so fresh?
William D. Cohan is a special correspondent for Vanity Fair and the author of the forthcoming book “Four Friends.”
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