This is a re-post of our 7th issue of our “WTF is going on with the Economy?” newsletter which details CLOs. You can read the original here. Get future issues delivered directly to your inbox. Sign up here.

Banks are in the lending business.

Let’s pretend that we own a business and want to finance a growth strategy.

We go to the bank to borrow money, and the story tends to go like this: 

• You go meet with your rep about your plans. 
• She invites you into her office (or to have a coffee, if you’re at one of the “cool” bank branches that think it’s a coffee shop), and you make your pitch.
• The bank reviews your proposal, your company’s risk profile, and how well you repaid your other loans. 
• The bank gives you a loan with an interest rate corresponding to the analysis above.
• You get to work on your project, repaying the loan along the way.

Sounds familiar, right? What happens next isn’t really talked about out loud. 

Each month, you send the money to your bank.  And, in your mind, you’re paying them back the money it lent to your company. 

After all, the banks need that money so they can lend more and generate revenue.

Except, your bank doesn’t hold your loan anymore.

Instead, it took your loan, put it together with hundreds of others, and sold it. 

Wait, what? Why would they do that?

There are a couple of reasons. 

First, banks like having cash so that they can…make more loans. Selling off your loan to a third party puts money in their pockets immediately.

Second, banks sometimes realize that they took too much risk (it’s cool, take a minute to laugh). In these cases, it’s more cost-effective to sell the loan than to keep it on their books. 

By packing the loan with others, the bank gets cash immediately while removing some risk. 

This bundle of loans goes by the fancy name of “collateralized loan obligations” or CLO. 

These initials might ring a bell. 12 years ago, CLO’s cousin, the “collateralized mortgage obligation” or CMO, took down the global economy.  A CMO (which still exists) is a collection of individual mortgages. CLOs, on the other hand, are made from various types of corporate debt. 

While not talked about often, the market for CLOs is enormous.

As of late last year, the global corporate bond (loan) market was worth 20 trillion US dollars.  If you’re keeping score at home, that’s 137.93 Jeff Bezoses worth of corporate loans (which says a lot about both the debt market and Amazon).  Not every corporate bond is in a CLO, but there are nonetheless trillions worth of bonds wrapped up in them.

So how do CLOs work? 

Long story: it’s complicated. Banks, like lawyers, are masters of superfluous bull poop. 

In short, a CLO works like this. 

• A collection of banks sells their loans to what’s known as a CLO trust (a trust is a legal entity that separates the assets from the owner and manager).
• The CLO trust divides the loans into different risk categories, depending on how likely it is for the borrower to repay the loan.
• The trust then sells these different shares, known as “tranches” in finance-speak, to investors. 
• The investors get a return based on the risk level of the tranche. 
• Importantly:
  • Tranches with the highest risk pay the highest interests but
  •  Tranches with the lowest risk get paid first.
• Investors consider the investment safe(ish) because the CLO puts a couple of safeguards in place. These controls include limiting the number of high-risk loans, diversifying the collection, and taking extra collateral to cover losses.

The 2015 film “The Big Short” centered on the CMO market. This clip from the movie explains the structure quite well. CLOs operate similarly, so it’s worth checking out.

(Remember: banks, like lawyers, are masters of superfluous bull poop). 

Like CMOs, banks are some of the most prominent investors in CLOs. This relationship means that banks create a bunch of loans then indirectly sell them to other banks. 

Now herein lies the problem.  If the economy doesn’t come back to life soon, private investors will stop giving companies money.  Yet, businesses will continue to have bills to pay. If companies can’t make money, they can’t reimburse their loans.  If they can pay back their loans, then the lenders don’t get their money back. 

Also, interest rates were historically low over the last decade. This “cheap money” made it all too easy for companies to borrow way more money than they should have.

Today, many companies are in a position that we call “over-leveraged,” meaning they borrowed more than they should have. The result? A wave of defaults and downgrades that would ripple through the CLO market. And with banks holding the lion’s share of CLOs, a banking crisis could be looming on the horizon.

(Also: Remember: banks, like lawyers, are masters of superfluous bull poop).

What’s the likelihood of the CLO market going bottom-up? 

For right now, the CLO market is relatively stable. 

Central banks around the world are buying massive amounts of bonds. Unlike in the last crisis, high-interest loans (called “junk,” “speculative,” or “high yield” in bond talk) are eligible for these relief programs. This eligibility helps soften the blow of the economic freeze, shielding CLOs to a certain extent.

Moreover, the built-in protections like extra collateral and diversification give CLOs some breathing room. Here, they can sell off some assets to cover costs. That said, those protections can only go so far.

Like practically anything right now, the CLO market is subject to rapid change. No one knows what the economy will look like once the lockdowns end. If things go south for the market, banks, insurance companies, pension funds, and other big CLO, investors will suffer. 

Currently, talk of any issues with them remains in the realm of financial news. They’ll probably stay there for the time being. If you start reading about CLOs in your local paper, then it’s time to brace yourselves for yet another colossal crash.