“The Fed first tried to justify the loans by saying they were a short-term measure to stem a liquidity crisis. But the so-called “liquidity crisis” has not prevented the stock market from setting new highs since the loan operations began on September 17. And the short-term operation has been running every business day since that time and is currently scheduled to reach into next year or last permanently. A cumulative total of approximately $3 trillion in overnight and longer-term loans has been funneled to unnamed trading houses on Wall Street without either the Senate or House calling a hearing to examine what’s really going on.” – Wall St On Parade
The analysis below is an excerpt from my November 24th issue of the Short Seller’s Journal
“Credit deterioration is a typical symptom of the end of a cycle — and that is exactly what Credit Benchmark is finding, particularly in the industrial sector.” – Bloomberg News in reference to a report from Credit Benchmark on the deterioration in credit quality of the industrial sector globally.
Credit Benchmark offers data/analytic services which provide forward-looking insights into the credit quality and liquidity of companies and sectors globally. Credit deterioration is a typical symptom of the end of an economic cycle. Credit Benchmark also noted last week that U.S. high-yield corporate credit quality has been crumbling since early 2019.
High yield debt sits below and props up leveraged loans held by banks, pension funds and CLO (collateralized loan obligations) Trusts. Leveraged loan credit quality is also declining, with many loan issues trading well below par and a not insignificant portion trading at distressed levels. Banks have been stuck with a lot of leveraged loans that were underwritten with the hope of sticking them in CLO investment structures. But big investors have been pulling away from CLO’s since mid-summer.
A CLO is a type of collateralized debt obligation. An investment trust is set-up and structured into tranches in order of “safeness,” with credit ratings assigned to each tranche ranging from AAA down to the “residual” or mezzanine/equity layer. Each tranche is sliced into bonds which are sold to investors, primarily institutional and wealthy investors, who invest in the various tranches of the CLO based on relative appetite for risk. Typically hedge funds and/or the underwriter of the CLO will provide funding for the mezzanine/equity layer.
Leveraged loans underwritten by Wall Street are pooled together and the interest and amortization payments are used to fund the interest and amortization payments of each layer of the trust. Each tranche receives successively higher rates of return to compensate for the level of risk. In addition each tranche is amortized based on seniority. If and when enough loans in the trust default and cash collected by the CLO trust is insufficient to pay off all of the tranches, the losses are assigned in reverse order from bottom to top. During the financial crisis, losses spread into the highest-rated tranches.
Invariably, as yield-starved investors grab for anything with a higher yield than is available from relatively riskless fixed income investments like Treasuries, agency debt (FNM/FRE) and high-grade corporate bonds, the underwriting standards of leveraged loans deteriorate. Wall Street requires loan product to feed the beast in order to continue raking in fat fees connected to this business. And, as you might have guessed, Wall Street opportunistically offers credit default derivative “insurance” products structured around the CLO trusts.
As I’ve detailed previously, credit rating downgrades in leveraged loans are mounting as the level of distress in the asset class rises. CLO’s purchase roughly 75% of all leveraged loans underwritten. In theory, CLO trusts are “over-collateralized” to account for a certain level of loan default and to ensure the top tranche receives the highest credit rating possible. But it would appear that many of these CLO trusts are starting to incur losses at the lowest tranches. This fact is reflected in the rececent performance of CLO bonds since June. As an example, through June, double-BB rated CLO bonds threw off a 10% ROR (interest payments and bond price appreciation). But by the end of October, this 10% ROR was wiped out, meaning the value of the bonds has fallen 10% since June including 5% alone in October.
The chart above plots the SPX vs an index of “generic” CLO triple-B rated bonds. The negative divergence of the CLO bonds reflects the escalating degree of distress in leveraged loans, which are underlying collateral funding the CLO trusts.
I am certain that part of the reason the Fed has had to start bailing out the banking system with its not-QE QE repo operations is connected to the rapid deterioration in the CLO/leveraged loan market. Chunks of thes CLO’s and leveraged loans are sitting on bank balance sheets.
The 2008 financial crisis was primarily triggered by the collapse of collateralized subprime mortgage CDO’s (these were the securities featured in “The Big Short”). I believe – and I’m not alone in this view – that CLO’s will cause the same type of systemic damage . The CLO market is roughly $680 billion just in the U.S. That was about the same size as the subprime mortgage market by 2008. Including the offshore market, the global leveraged loan market is now $1 trillion, doubling in size since 2010.
Most people think of the Fed when they hear the term “repo.” But the repo market primarily is funded by banks and money market funds. CLO bonds have been used as repo collateral for several years. As the credit quality of this asset class declines, banks are less interested in participating in repo market funding transactions to avoid the rising probability of suffering a counterparty default from use of CLO collateral, thereby reducing liquidity in the repo market.
In addition, many banks have been stuck with leveraged loans that could not be offloaded onto investors or CLO trusts. This inability to off-load loans into CLO’s started this past summer when the largest investor in CLO’s, a large Japanese bank, began to pull away from the CLO market. As the value of these loans declines, banks are forced to increase the amount of capital required to maintain reserve ratios – another reason for the Fed repo market intervention.
As the global economy, including the U.S. economy notwithstanding the insistence to the contrary by the Fed and Trump, continues to contract it’s quite probable that CLOs/leveraged loans will begin to melt-down Chernobyl-style. Referring back to the SPX/CLO bond price chart above, in my view there’s no coincidence that the Fed’s intervention in the repo market commenced at about the same time the triple-B CLO bonds began to take a dive. That price decline is even more pronounced for the tranches with ratings below triple-BBB.
To be sure, CLO’s are not the only financial wildfire outbreak targeted by the Fed’s money printing, but I would wager a healthy amount of gold coins that distress in the CLO market is one of the primary troubles right now. And the problem is magnified when you take into account the credit default swap transactions “wrapped around” these CLO trusts. These derivative trades also require an increasing amount of collateral as CLO tranche distress escalates.
To accompany the above analysis in my Short Seller’s Journal, I presented some ideas for expressing a bearish view based on the the eventual collapse in the CLO/leveraged loan market. You can learn more about this newsletter here: Short Seller’s Journal information.