It might be pure accident that one of the most important financial innovations of the past 20 years carries the clunky name "collateralized loan obligation." Or it might be that the wizards behind the instrument could work their magic best behind a curtain of baffling adjectives and nouns. So far the instruments have escaped major scrutiny. But while market watchers have spent the past few years wringing their hands over hedge funds, CLOs have become an even more integral part of the financial system--and just as worrisome.
They'renovel creations. CLO managers essentially buy a bunch of loans arranged by banks, package them together into a pool, and then carve out different securities to sell to investors, taking a fee for their troubles. While the loans they collect are mostly "junk"--meaning they carry low credit ratings--the securities that come from the pool are mostly "investment-grade," carrying high ratings. Ironically, that attracts people seeking the very safest investments.
But can you really squeeze that much safety out of that much risk? The idea is that the risks are so dispersed that most investors end up doing well. Yet there's something akin to a perpetual-motion machine at work here. How long can it go on?
Think of CLOs as the next step of financial innovation that started with junk bonds and mortgage-backed securities, which revolutionized the mergers-and-acquisitions and mortgage businesses, respectively, in the 1980s. Now CLOs are doing the same for the $500 billion commercial lending market. They're making capital cheaper for companies, lowering the risk for lenders, and, so far, providing investors with enviable returns. CLOs are powering two other arenas, too: the private-equity business, which counts on them for financing, and the $14 trillion stock market, which has been propped up recently by furious buyout activity. Without CLOs, leveraged buyouts like the record $27 billion deal for hospital operator HCA Inc. (HCA ) wouldn't be happening on such a grand scale.
Wall Street is pushing CLOs with full force. Year to date, CLO managers have gathered in $90 billion, double last year's pile at this point, which was double the year before that. "Just about every man and his dog is trying to do a CLO at the moment," says Michael Peterson, editor of Creditflux, an industry news service.
In fact, unbeknownst to many, CLOs are pumping up the entire U.S. economy. By lowering borrowing costs and attracting foreign capital, they're helping to keep a lid on interest rates. For years economists have professed amazement that long-term rates have stayed low even as short-term rates have risen. Innovations like CLOs are a big reason why. They've kept the gears of the world's biggest economy so well-oiled that foreign investors can't help but be attracted to it.
But while financial innovations fuel booms, they also tend to worsen busts. Wall Street's lack of willpower is legendary. The pattern goes like this: Come up with a brilliant idea, nurture it until it catches on, then flog it until it breaks. So far, the market has performed smoothly. But CLOs are financing dicier endeavors all the time. They've encouraged companies to take on more floating-rate debt, which could cause problems like those now being felt by homeowners who took out adjustable-rate mortgages a few years back. CLOs also have encouraged companies to put up more of their assets as collateral for lenders, which during hard times could hinder their financial flexibility. And CLOs' successes so far have lulled investors into a false sense of security: Sometime in the next few years, a blowup is likely--one that could sink an already foundering economy. "The losses are going to be more severe in the next downturn," says James Grant, editor of Grant's Interest Rate Observer.
CLO managers are using financial engineering techniques dating back to the emergence of junk bonds. For borrowers, loans are preferable to bonds, which fueled the last buyout boom, because loans can be repaid at will. CLO deals first appeared in the early 1990s and picked up speed as the loan market grew to include commercial bank loans. By 2002 the structures were being designed well enough to rekindle corporate lending after the telecom bust.
Their ingeniousness allows them to haul in more money from investors than Wall Street could raise with an army of its finest salesmen. Essentially, the devices vacuum up junk-rated leveraged loans and, voilà, turn out investment-grade notes. Think of a CLO as an upside down pyramid in which a few people at the bottom support many at the top. A CLO's top tiers of securities receive AAA and AA credit ratings. These rate so highly because they're insulated by the lowest-ranking securities, which are the first to suffer any losses. Recently CLOs have been collecting yields from their loan pools about 1.9 percentage points greater than the yields they're paying on the rated notes they've issued. The difference goes to investors holding the unrated securities issued by the CLO; it's the premium they get for the risk of losing everything if the loans go bad. "It is highly levered and has the risk that it will just blow up totally," says Mark H. Adelson, head of structured finance research at Nomura Securities International Inc. Similar structures, all coming under the heading of collateralized debt obligations, are being deployed to funnel billions into home mortgages and derivatives on investment-grade corporate debt.
By carving up the loan pool into different risk levels, CLOs have been able to corral billions of dollars from insurance companies, pension funds, and ultrawealthy individuals around the world who crave AAA-rated investments and nothing less--certainly not loans to fund LBOs. "Now there's a whole new class of buyers coming into the market," says Gerald DeVito, co-head of the Global Cash CDO Group at CreditSuisse (CSR ). Better yet, says Ian H. Giddy, a structured finance consultant, "There is a virtually unlimited amount of capital to go into triple-As."
That power to raise money has not been lost on the buyout barons. Many have started their own CLO operations, not so much to fund their own deals as to get in on the action. Kohlberg Kravis Roberts & Co., the big LBO house, two years ago started its own CLO, KKR Financial Corp., (KFN ) which it took public last year with a chief executive recruited from Wells Fargo & Co. (WFC ) Competing buyout giants Bain, Blackstone Group, and Carlyle Group also have affiliates managing CLOs. They can see firsthand the immense capacity of investors to finance loans that in the past were held mostly by banks.
Buyout firms are benefiting from the momentum CLOs have built up since 2002. The vehicles have attracted investors by holding floating-rate assets during years when short-term interest rates were rising. They've also looked good because their loans are secured by the assets of the borrowing companies, which means they'll retain more of their value in bankruptcy than unsecured bonds, like those wiped out in 2001 and 2002 during a wave of defaults. By refinancing existing corporate debt on better terms and by supplying money for companies to heal and grow again after the last recession, CLOs have helped drive default rates down to 20-year lows. Hedge funds have added to the enthusiasm by loading up on junk loans. And the economy has grown, allowing companies to pay down debt and adding to the confidence of CLO investors. It's a virtuous circle. Things have gone so well, says one investment banker, that now smaller foreign commercial banks, notorious trend followers, are aggressively buying loans.
But the money is getting too easy for everyone's good. Some credit market veterans are starting to kick around the old banking maxim that the worst loans are made in the best of times. "Times are good, default rates are low, and you're probably seeing loans that in a few years will seem far too generous," says Louise Purtle, senior analyst at CreditSights Inc., a research service for institutional investors. "You've got classic cyclical behavior happening right now." Mark L. Gold, co-founder of HillMark Capital, a CLO manager, says: "If you look at the record issuance [of loans] that's been done, clearly you're setting the stage for record problems."
The immediate concerns are loans to auto industry suppliers, homebuilders, and suppliers to the homebuilders. Homebuilders alone account for about 5% of loans outstanding, big enough to matter but small enough not to panic the bulls.
Ultimately, loans made for LBOs could cause the most trouble. Those deals often come with risky business reorganizations. "You are more exposed to uncertainty," says Purtle, in a bet that "gets away from proven assets, proven management, and proven cash flows." With loans from the same big deals spread throughout CLOs, the chance of LBO defaults, says Gregory J. Peters, chief credit strategist at Morgan Stanley (MS ), "is the No.1 risk factor" to the CLO-fueled boom.
Worrisome signs are mounting. The amount of leverage used in deals right now is greater than the previous record set in 1997, according to Standard & Poor's LCD, a loan tracker and, like BusinessWeek, a unit of The McGraw-Hill Companies (MHP ). At the same time, loans are carrying lower ratings, with fewer safeguards, than at any time since the late 1990s. The worse mix suggests that in a recession on the order of the one in 1991, default rates would soar more than four percentage points beyond the record 12.8% set that year, says Martin Fridson of FridsonVision, a research service. Similarly, CLOs are accepting more so-called second-lien loans. Like second mortgages, these are backed by borrowers' assets, but their claims on that collateral come second. "Second liens could be the potential Achilles' heel of the current credit cycle," says Gold, the CLO manager at HillMark.
Another concern: CLO managers' preoccupation with keeping the right mix of loans in their pools to technically satisfy rating agency guides. Fundamental credit analysis of borrowers' ability to repay loans is being shortchanged, says Simon A. Mikhailovich, managing director of Eidesis Capital, a hedge fund group specializing in structured credit. In other words, investor diligence has been less than due: A pool of 85 diverse loans may look good by the rating agencies' statistical and historical models but still hold bombs. "More and more, there is an actuarial approach to credit analysis rather than the old-fashioned practice of looking each borrower in the eye," says Grant.
The full consequences of the CLO boom won't be known until business slows and borrowers can't raise more money to keep going. That may not happen for a while. S&P predicts that defaults will increase over the next 24 months but remain under the long-term average. The reason: continued economic growth and strong liquidity in the credit markets. Best would be for a gentle cooldown to give CLO fever some time to pass. But that's not likely to happen. Wall Street just doesn't work that way.