17 ms·

Wall Street’s Latest Love Affair with Risky Repackaged Debt

226 points by cow9 8y ago

aetherspawn 8y ago
ELI5 would be appreciated here for those of us who aren’t stock investors to understand this.
- kgwgk 8y ago
  https://www.zerohedge.com/s3/files/inline-images/CLO%20for%20dummies.jpg https://www.zerohedge.com/s3/files/inline-images/CLO%20for%2... Debt from multiple issuers is pooled and sold by pieces to investors with different risk profiles. The more risky layers will be the first touched if there are problems, but pay better in the best case. High risk (variation in expected returns), high (expected) return. The idea is the "good" part of product (the AAA layer) is very safe... according to the model. But it may not be so safe after all if things don't go as expected.
- grey-area 8y ago
  The 2018 crisis was caused by CDOs - packaged mortgage debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension). https://www.youtube.com/watch?v=xbiDrzTd8fE https://www.youtube.com/watch?v=xbiDrzTd8fE The article is saying that people are buying CLOs - packaged corporate debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension). TLDR: History repeats itself, first as tragedy, then as farce.
piokoch 8y ago
Reading this made me speechless. One thing is that the same story repeats again (I am only curious if someone is playing against CLO now as "The Big Short" guys did.) But this... "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 [...]. These wiseguys then do everything they can to force the company into a bankruptcy filing. [...] Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely." Isn't this insurance fraud? It looks for me like this: I am buying a crappy car, I am somehow able to insure it for a large amount of money (exceeding car value), then I am putting this car on fire and grab insurer money.
- arethuza 8y ago
  It might not literally be insurance but something like a Credit Default Swap - which are similar to insurance but with some important differences: https://en.wikipedia.org/wiki/Credit_default_swap#Differences_from_insurance https://en.wikipedia.org/wiki/Credit_default_swap#Difference...
  - lucozade 8y ago
    They are referring to CDSs. It's called out explicitly in the article.
- csomar 8y ago
  For car insurance you need to buy a car. For debt insurance, not really. I think the editor meant "debt options" but used the word insurance because he was targeting a non-sophisticated audience. Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
  - cinquemb 8y ago
    > Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy? Well, right now, "somebody" is selling long dated OTM put options on some ETF's that are filled with +95% junk rated bonds and/or CLO's, with some of the strikes having +100k OI for pennies on the dollar (ex. HYG60P12202019), which in normal times might be easy money from selling… I'm sure the big boys have better ways of getting exposure as well.
- rocqua 8y ago
  CDS is often pitched as insurance, but the contracts aren't written that way. Instead its closer to a simple: if company defaults: auction debt payout = (face value - auction value) * contract amount
- lucozade 8y ago
  > I am only curious if someone is playing against CLO now as "The Big Short" guys did Absolutely they are. The heroes of The Big Short weren't doing anything particularly unusual or special. They were just using credit instruments to bet that they'd be more foreclosures than the market was predicting. There'll be equivalent hedgies doing the same with corporate debt now. > Isn't this insurance fraud? No because it's not actually insurance as others have said. They're using similar credit instruments to bet against corporates that the Big Short folk used to bet against mortgages. Is what they're doing ethical? Probably not though you have to be careful. If you look at the Windstream example linked in the article, I'd argue that the hedgie is using ethically questionable methods to expose, and take advantage of, ethically questionable corporate practice. Not entirely clear who the villain is with that one. Probably both parties.
isoskeles 8y ago
> Those investors include Japanese banks as well as investors in hedge funds, mutual funds and pension funds (in other words, you and me). I laughed. You and me, NYT reader who is rich enough to have a 401k. > 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? I hate to be that guy, but at what point can I blame the Fed for near-zero interest rates that have motivated traders to seek higher gains? I appreciate that people are being more vigilant about reporting on this, but I’m starting to think blaming it on the traders is the easy way out. It seems especially easy when we can draw obvious comparisons to 2007-8 (CDO => CLO, that’s just one letter changed it must be the same thing!). And it sounds like even if these traders weren’t trying to force overleveraged companies into bankruptcy, those companies must be in a precarious enough position that it could happen on its own. Am I mistaken?
- pjc50 8y ago
  The near-zero interest rates aren't low enough. Small negative rates are probably required to suck some money out of the speculative economy. > motivated traders to seek higher gains A trader who doesn't seek higher gains is a shark that stops swimming and dies. There's no need to blame interest rates for this.
  - rpz 8y ago
    Negative rates won't send traders out of business. There are still plenty of trades to make in a negative rate environment. In any case, I'd be interested to hear your argument on why small negative rates are good for the economy in general.
    - Nasrudith 8y ago
      Not the poster but the theory is that it discourages deflationary behavior of funds sitting around and keeping demand down. Personally I suspect that it is overly risk boosting and encourages economically perverse behavior but it apparently hasn't proven disastrous yet in the locales that have tried it.
  - 8y ago
RubberbandSoul 8y ago
I have this growing conviction that some of the people working in financial markets are something akin to black hat hackers. They continuously probe the system for bugs and weaknesses and then exploit them for profit. This "collateralization with obfuscation" exploit where it's impossible to calculate the risks of bundled investment packages should have been "patched" with legislation after the 2008 crash but wasn't. So, unsurprisingly, they go after it again.
- bko 8y ago
  Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products. > The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated. The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher. I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit. [0] http://www.leveragedloan.com/sp-report-clos-show-strong-historic-performance-with-few-defaults/ http://www.leveragedloan.com/sp-report-clos-show-strong-hist...
jimmy_ruska 8y ago
Why would they fix the problem. Every crash is a redistribution of wealth. When there's a recession, if you're wealthy and have diversified assets you can buy everything at a discount rate during a stock crash and sell when the recession recovers. Meanwhile, the poor and middle class often find themselves unemployed, their savings accounts massively depleted and in a constant crush for cash. If you're wealthy AND you have the ability to create risk in the market, then even better. You can actually help trigger more "stock discounting" events, and dominate any emerging technology company with your bootstrapped companies while everyone is dying for credit.
- sprafa 8y ago
  The risk is social, the profit is private. Same as 2008. The entire sector needs to be completely rethought of, and regulated aggressively if they are to provide any public good.
- RubberbandSoul 8y ago
  It's a kind of extortion on a national or even global scale. "Nice economy you have there. Shame if anything would happen to it." Nassim Taleb's suggestion is to simply deny institutions the option of growing large enough that their demise would threaten the system. Once an entity gets too large to fail it should be split so that the remaining pieces can fail individually without dragging entire system with it. This would get rid of the moral hazard "heads I win, tails someone else loses".
  - DataWorker 8y ago
    I love the idea of breaking up google. I don’t think it will happen though as they have a lot of political power, much more than the users whom they extort.
    - orthecreedence 8y ago
      > they have a lot of political power Exactly why it makes sense to limit corporation size. Honestly, I think things would be much better off with a progressive tax on the number of employees and contractors a corporation has. Anything up to 10000 is 0%, and after that, the brackets go up to 80% (for 1 million or over).
pepy 8y ago
paywall help anyone?
- peteretep 8y ago
  If you look on the comments page, under the title is a link that says "Web" click on it, and then follow the first link.
  - pepy 8y ago
    guess we dont have the same first link, waiting for someone to archieve.is- it
    - michaelmrose 8y ago
      http://archive.is/dKiAg http://archive.is/dKiAg
oli5679 8y ago
Does anyone understand the logic of this statement? I can't make heads of tails of it, which lowers my trust in the article overall. If people are arbitraging derivatives priced differently to underlying asset then that seems pretty benign to me? Is there something else going on here? 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.
- haroldl 8y ago
  I think the analogy is to suppose you insure your car with 10 different policies and then total it so you can collect 10x what it is worth.
bitxbit 8y ago
Wall Street’s Love Affair with Financial Alchemy. Modern finance, particularly how we define risk (and volatility), is deeply flawed.
qpotlpus 8y ago
CLOs are not inherently good or bad. The difference is in how they are structured and priced. On the benefit side, CLOs have effectively permanent financing in place which takes the liquidity run risk off the table (and thus is more systemically stable) than loans funded with bank deposits.
manyhats 8y ago
1. It's important to distinguish between liquidity risk and solvency risk. Liquidity risk is needing to sell an asset that is fundamentally sound and not being able to get a fair price, or any price at all (as happened in 2008/2009 - no/few buyers and many sellers). Solvency risk is the asset goes bad and there's a permanent impairment. Simplistically: liquidity risk = broken leg (painful and needs immediate treatment, but recovery over time likely) solvency risk = horrible cancer 2. CLOs are made up of bank loans, which are generally the most senior obligation of a company, and are the least risky. Bonds, preferred equity and common equity get hit before the loans are impaired. During the period from 1998 through 2016, defaulting loans recovered 66% of their value while bonds recovered 40%. [0] 3. CLOs generally made it through 2008/2009 without any major issues. The structures held up as designed, but prices fell along with other structured products since there were few buyers and many sellers. If you were able to hold, you did reasonably well. Over the 20 year period from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted (no AAA or AA defaults) and had a 0.04% loss rate. [1] 4. What has changed since 2008 is that loans are becoming a larger portion of the total value of the business (loan-to-value). This means that if the business goes bad, there's less of a cushion for the loan and recovery rates will be lower. I don't know how much lower, but some of the junior tranches in a CLO could be impaired in a severe downturn. It's hard to really know, but I _think_ things would need to be worse than 2008 (or the same level of crisis, for a longer period) for AAA tranches in general to be permanently impaired. 5. Accounting plays a role here. If you are required to mark-to-market, then the market clearing price is what the asset is worth, regardless of fundamentals. If there's a panic, you may be a forced seller if you don't have sufficient reserves to get through the disruption and your mark-to-market loss becomes a permanent loss. This applies to any asset class, not just structured products. 6. I don't understand why the article brings up CDS gaming. It's a real issue, and one that is being worked on, but it's not even a rounding error compared to the size of the corporate debt universe. [2] quote from the FT article: "Isda’s method of “fixing” CDS has always been akin to “patching” software after hackers exposed weak points. When one window closes, traders simply find a new one." [0] "JPMorgan Default Monitor 4Q16" [1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013” [2] https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32aece https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32a...
lefstathiou 8y ago
CLOs are comprised of loans made to small businesses. Small businesses are inherently risky. CLOs exist because they are a relatively inexpensive form of long term funding. Let’s ponder the type of people who start and operate small businesses and whether or not they get access to competitive bank financing... Once upon a time, seeing entities willing to write loans to small business was worth celebrating. Amusing that once we find out it’s Wall Street stepping in to facilitate this at a scale the government cannot, it is dangerous gambling.
- kgwgk 8y ago
  I don’t know what’s the definition of “small business”, but the size of these loans is typically tens or hundreds of millions.
  - w4 8y ago
    The definition of "small business" varies a lot. You probably think of a locally owned dry cleaner or coffee shop when you hear the term "small business." I know that's what I think of when I hear the term. But in the context of lending, the definition of "small business" (usually lumped together with mid-sized businesses under the umbrella term "SMBs") is usually something like <$50MM in annual revenue, or <100 to <500 employees, depending on who you're talking to. They can be quite large compared to what most people think of when they hear "small business," but they're small when compared to large enterprises. This categorization speaks less to the size of the businesses themselves, and more to the scales that these banks operate on. After all, $50MM annual revenue or 500 employees seems pretty darn big to me!
- marcosdumay 8y ago
  There is absolutely no problem in making risky loans. But there are many problems with packaging those loans together and selling them to a third party that can't calculate its risk level claiming it's low risk.
  - lefstathiou 8y ago
    An important clarification here: CLOs are sold to multi billion dollar asset managers (technically referred to as QIBs, entities that manage at least $100mm in Assets Under Management or more - the vast majority of the structured products business is dominated by large fund managers). It is the highest tier of investor "suitability" recognized by the SEC. It's their job to understand these products and they have armies of people for it. It can take weeks to "market" these transactions and plenty of opportunities to sit down with bankers and CLO managers to get smart on the space. There is also a ton of supporting technology and research, all of which is available for free on S&P, Moody's, Fitch, Kroll and Morninstar's websites. If you cannot sell this stuff to a QIB, who can you sell it to?
ikeboy 8y ago
The article is conflating two distinct issues - CDS warping incentives, and CLOs. CDS is primarily relevant to bonds that trade on the open market. CLOs are packaging private loans made by banks, not bonds. To treat them as relevant to each other demonstrates the author has no clue what they are talking about.
- mlevental 8y ago
  >By William D. Cohan https://williamcohan.com/about/ https://williamcohan.com/about/ who shall i believe? you or him?
  - ikeboy 8y ago
    Don't know what to say then. Maybe the editor insisted this crap be included?
redwood 8y ago
What's the relative size of this market, particularly the high-risk segment in comparison to the size of the subprime mortgage segment and associated CDOs in the 2008 crisis? Without a sense for whether the order of magnitude is similar, it's hard to draw conclusions on the level of systematic risk.
- ddoolin 8y ago
  The article says that leveraged corporate loans make up about $1.2T. Wikipedia says the subprime mortgage market was around $1.3T in March 2007. https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subprime_mortgage_market https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subpr...
  - redwood 8y ago
    Wow thanks. That certainly makes things more acute! I suppose businesses are structurally different from home buyers in a number of ways: for example when a business goes bankrupt (correct me if I'm wrong) creditors are paid out to the extent they can be. Whereas when a home owner goes bankrupt I believe they can get out of their obligations entirely.
b0bby_tabl3s 8y ago
The ole' shell game.
nimbius 8y ago
I see a lot of comments in the article on how this is just a scare piece, but it bears remembering just how big of a crisis the 2008 financial collapse was. Stagnant wages in the 90s gave rise to credit cards and personal debt-as-a-feature capitalism, which was immediately blown out of the water by 2008. people lost their homes because the credit system keeping them afloat basically collapsed. businesses started shedding employees and shuttering doors, while banks across the world began a series of spectacular failures. Not just banks and auto makers, but capitalism itself looked to be slowly collapsing under its own weight of the hubris of mankind. Its really stunning to look back at some of the absolutely bombastic thing we said and did in the service of not people who were displaced and destitute after this collapse, but in the service of trying to keep capitalism going for ten more years. At some point we started bribing people to participate in the market that just made them homeless with "cash for clunkers." This was an asinine program designed to "boost the economy" by paying people to destroy their already running vehicles under the guise that they caused too much pollution. This didnt work. It could never work, and so we switched tactics toward simply bailing banks and auto manufacturers by cutting trillion dollar checks and printing more cash. Nobody who caused the financial collapse was ever arrested, save perhaps Bernie Madoff for his high treason of swindling the plutocracy. At the last few months of the term of George W Bush, a round of "stimulus checks" were cut and sent back to americans. The idea here was that americans would buy new televisions and sneakers. The reality for many, including me, was that money went to savings or closing out credit card accounts we didnt need. And here we are, once again, at the brink of another 10 year cycle. Things seem fine but theres hand-wringing from the usual suspects about systems of credit and debt so complex they cannot possibly exist outside a PhD thesis.
ssrcity 8y ago
A major issue in 2008 were loans made with no credit standards and investors were being sold what they thought was AAA credit risk when in reality the borrowers behind the securities were people with little income make the mortgage payments they were obligated to. The article at hand does little to prove that a similar phenomenon is going on with corporate bonds. Would be interesting to know whether the corporates spoken about here are public or private companies since, if they are public, any going concern can easily be analyzed via a company’s SEC filings. There’s no doubt that the structure of this product is similar to products which caused the financial collapse, but are all the other systemic issues present? I don’t think the author addresses that.
asabjorn 8y ago
If you put this is context of long-term economic stagnation where the kind of predictable growth modernity brought over two hundred years is no longer there, then for people that are expected to generate large returns have a large incentive to take on riskier investments that might give an growth upside. Eric Weinstein argues [1] that what we are experiencing is a long-term stagnation of western economy, and arguably any economy that is not catching up. This is in his estimation the cause of many of our issues. [1] https://www.youtube.com/watch?v=TKeMIWVOnbo https://www.youtube.com/watch?v=TKeMIWVOnbo
4RealFreedom 8y ago
A lot of good comments. I just wanted to point out that the last line in this article states 'Why do investors fail to learn the harsh lessons about risk, even though the consequences of them still remain so fresh?' Speaking about the past market problems, if no one is held accountable why should change occur?
- michaelmrose 8y ago
  At the top where it matters they don't experience as many negative consequences long term as middle class and down. If they lose half their wealth they don't buy a new boat this year.
zelon88 8y ago
Here's a heartwarming tale of a man who got a call from a debt collector with a fake note threatening to rape his wife. It started his years-long crusade to bring down the loan sharks responsible for selling fake debt with his name on it..... https://www.bloomberg.com/news/features/2017-12-06/millions-are-hounded-for-debt-they-don-t-owe-one-victim-fought-back-with-a-vengeance https://www.bloomberg.com/news/features/2017-12-06/millions-...
m101 8y ago
There are a number of errors in this article, and there are important things that articles like this fail to mention: - the loans aren't made by the banks and then shifted, they are more often sold to investors without the bank assuming any of the loan themselves (it's called loan syndication). The bank simply acts as the role of arranger. - the Japanese investor base is mostly in the most senior part of the capital structure - for similar credit ratings CLOs have far lower default rates than for equivalent corporates. It's something like 2-3% in the B and BB rated tranches through the crisis - the average piece of CLO equity returned something like mid-single % digit returns if held through the whole of the financial crisis - the paragraph on credit default swaps is a distraction. No CLOs use credit default swaps, and certainly no one sells credit default swaps which reference CLO tranches. This happened prior to the financial crisis through synthetic-CLOs but these don't exist anymore. Sometimes investors in CLOs use credit default swaps against an index of credits (like XOVER for instance), but this doesn't really work as a CLO hedge The facts are that many lessons have been learned since the crisis and people aren't doing the same things they did back then. What can be said is that there is a race to the bottom in terms of loan covenants diminishing, but this is driven by larger demand for loans than supply resulting in borrowers achieving looser document terms. The drivers of this are often the law firms that work on behalf of the borrowers who promise being able to achieve looser and looser language with a view to winning the business. Unfortunately the lenders have a weak hand in this situation as they are many chasing few assets and find it difficult as individual institutions against a syndicating bank and borrower who have full information and can play lenders off against each other.

226 points by cow9 8y ago

aetherspawn 8y ago

ELI5 would be appreciated here for those of us who aren’t stock investors to understand this.

kgwgk 8y ago
https://www.zerohedge.com/s3/files/inline-images/CLO%20for%20dummies.jpg https://www.zerohedge.com/s3/files/inline-images/CLO%20for%2... Debt from multiple issuers is pooled and sold by pieces to investors with different risk profiles. The more risky layers will be the first touched if there are problems, but pay better in the best case. High risk (variation in expected returns), high (expected) return. The idea is the "good" part of product (the AAA layer) is very safe... according to the model. But it may not be so safe after all if things don't go as expected.
grey-area 8y ago
The 2018 crisis was caused by CDOs - packaged mortgage debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension). https://www.youtube.com/watch?v=xbiDrzTd8fE https://www.youtube.com/watch?v=xbiDrzTd8fE The article is saying that people are buying CLOs - packaged corporate debt which is going to default, mixed and dressed up as very safe debt, then sold on to some poor sucker (including you in your pension). TLDR: History repeats itself, first as tragedy, then as farce.

piokoch 8y ago

Reading this made me speechless. One thing is that the same story repeats again (I am only curious if someone is playing against CLO now as "The Big Short" guys did.) But this... "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 [...]. These wiseguys then do everything they can to force the company into a bankruptcy filing. [...] Since the insurance payment exceeds by far the overall cost of the discounted debt, the hedge fund profits handsomely." Isn't this insurance fraud? It looks for me like this: I am buying a crappy car, I am somehow able to insure it for a large amount of money (exceeding car value), then I am putting this car on fire and grab insurer money.

arethuza 8y ago
It might not literally be insurance but something like a Credit Default Swap - which are similar to insurance but with some important differences: https://en.wikipedia.org/wiki/Credit_default_swap#Differences_from_insurance https://en.wikipedia.org/wiki/Credit_default_swap#Difference...
- lucozade 8y ago
  They are referring to CDSs. It's called out explicitly in the article.
csomar 8y ago
For car insurance you need to buy a car. For debt insurance, not really. I think the editor meant "debt options" but used the word insurance because he was targeting a non-sophisticated audience. Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy?
- cinquemb 8y ago
  > Real life is a little bit different though. How many option sellers are you going to find if the company is easy to drive to bankruptcy? Well, right now, "somebody" is selling long dated OTM put options on some ETF's that are filled with +95% junk rated bonds and/or CLO's, with some of the strikes having +100k OI for pennies on the dollar (ex. HYG60P12202019), which in normal times might be easy money from selling… I'm sure the big boys have better ways of getting exposure as well.
rocqua 8y ago
CDS is often pitched as insurance, but the contracts aren't written that way. Instead its closer to a simple: if company defaults: auction debt payout = (face value - auction value) * contract amount
lucozade 8y ago
> I am only curious if someone is playing against CLO now as "The Big Short" guys did Absolutely they are. The heroes of The Big Short weren't doing anything particularly unusual or special. They were just using credit instruments to bet that they'd be more foreclosures than the market was predicting. There'll be equivalent hedgies doing the same with corporate debt now. > Isn't this insurance fraud? No because it's not actually insurance as others have said. They're using similar credit instruments to bet against corporates that the Big Short folk used to bet against mortgages. Is what they're doing ethical? Probably not though you have to be careful. If you look at the Windstream example linked in the article, I'd argue that the hedgie is using ethically questionable methods to expose, and take advantage of, ethically questionable corporate practice. Not entirely clear who the villain is with that one. Probably both parties.

isoskeles 8y ago

> Those investors include Japanese banks as well as investors in hedge funds, mutual funds and pension funds (in other words, you and me). I laughed. You and me, NYT reader who is rich enough to have a 401k. > 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? I hate to be that guy, but at what point can I blame the Fed for near-zero interest rates that have motivated traders to seek higher gains? I appreciate that people are being more vigilant about reporting on this, but I’m starting to think blaming it on the traders is the easy way out. It seems especially easy when we can draw obvious comparisons to 2007-8 (CDO => CLO, that’s just one letter changed it must be the same thing!). And it sounds like even if these traders weren’t trying to force overleveraged companies into bankruptcy, those companies must be in a precarious enough position that it could happen on its own. Am I mistaken?

pjc50 8y ago
The near-zero interest rates aren't low enough. Small negative rates are probably required to suck some money out of the speculative economy. > motivated traders to seek higher gains A trader who doesn't seek higher gains is a shark that stops swimming and dies. There's no need to blame interest rates for this.
- rpz 8y ago
  Negative rates won't send traders out of business. There are still plenty of trades to make in a negative rate environment. In any case, I'd be interested to hear your argument on why small negative rates are good for the economy in general.
  - Nasrudith 8y ago
    Not the poster but the theory is that it discourages deflationary behavior of funds sitting around and keeping demand down. Personally I suspect that it is overly risk boosting and encourages economically perverse behavior but it apparently hasn't proven disastrous yet in the locales that have tried it.
- 8y ago

RubberbandSoul 8y ago

I have this growing conviction that some of the people working in financial markets are something akin to black hat hackers. They continuously probe the system for bugs and weaknesses and then exploit them for profit. This "collateralization with obfuscation" exploit where it's impossible to calculate the risks of bundled investment packages should have been "patched" with legislation after the 2008 crash but wasn't. So, unsurprisingly, they go after it again.

bko 8y ago
Remember the Gall-Mann amnesia effect: expert believing news articles on topics outside of their field of expertise even after acknowledging that articles written in the same publication that are within the expert's field of expertise are error-ridden and full of misunderstanding While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products. > The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated. The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher. I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit. [0] http://www.leveragedloan.com/sp-report-clos-show-strong-historic-performance-with-few-defaults/ http://www.leveragedloan.com/sp-report-clos-show-strong-hist...

jimmy_ruska 8y ago

Why would they fix the problem. Every crash is a redistribution of wealth. When there's a recession, if you're wealthy and have diversified assets you can buy everything at a discount rate during a stock crash and sell when the recession recovers. Meanwhile, the poor and middle class often find themselves unemployed, their savings accounts massively depleted and in a constant crush for cash. If you're wealthy AND you have the ability to create risk in the market, then even better. You can actually help trigger more "stock discounting" events, and dominate any emerging technology company with your bootstrapped companies while everyone is dying for credit.

sprafa 8y ago
The risk is social, the profit is private. Same as 2008. The entire sector needs to be completely rethought of, and regulated aggressively if they are to provide any public good.
RubberbandSoul 8y ago
It's a kind of extortion on a national or even global scale. "Nice economy you have there. Shame if anything would happen to it." Nassim Taleb's suggestion is to simply deny institutions the option of growing large enough that their demise would threaten the system. Once an entity gets too large to fail it should be split so that the remaining pieces can fail individually without dragging entire system with it. This would get rid of the moral hazard "heads I win, tails someone else loses".
- DataWorker 8y ago
  I love the idea of breaking up google. I don’t think it will happen though as they have a lot of political power, much more than the users whom they extort.
  - orthecreedence 8y ago
    > they have a lot of political power Exactly why it makes sense to limit corporation size. Honestly, I think things would be much better off with a progressive tax on the number of employees and contractors a corporation has. Anything up to 10000 is 0%, and after that, the brackets go up to 80% (for 1 million or over).

pepy 8y ago

paywall help anyone?

peteretep 8y ago
If you look on the comments page, under the title is a link that says "Web" click on it, and then follow the first link.
- pepy 8y ago
  guess we dont have the same first link, waiting for someone to archieve.is- it
  - michaelmrose 8y ago
    http://archive.is/dKiAg http://archive.is/dKiAg

oli5679 8y ago

Does anyone understand the logic of this statement? I can't make heads of tails of it, which lowers my trust in the article overall. If people are arbitraging derivatives priced differently to underlying asset then that seems pretty benign to me? Is there something else going on here? 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.

haroldl 8y ago
I think the analogy is to suppose you insure your car with 10 different policies and then total it so you can collect 10x what it is worth.

bitxbit 8y ago

Wall Street’s Love Affair with Financial Alchemy. Modern finance, particularly how we define risk (and volatility), is deeply flawed.

qpotlpus 8y ago

CLOs are not inherently good or bad. The difference is in how they are structured and priced. On the benefit side, CLOs have effectively permanent financing in place which takes the liquidity run risk off the table (and thus is more systemically stable) than loans funded with bank deposits.

manyhats 8y ago

1. It's important to distinguish between liquidity risk and solvency risk. Liquidity risk is needing to sell an asset that is fundamentally sound and not being able to get a fair price, or any price at all (as happened in 2008/2009 - no/few buyers and many sellers). Solvency risk is the asset goes bad and there's a permanent impairment. Simplistically: liquidity risk = broken leg (painful and needs immediate treatment, but recovery over time likely) solvency risk = horrible cancer 2. CLOs are made up of bank loans, which are generally the most senior obligation of a company, and are the least risky. Bonds, preferred equity and common equity get hit before the loans are impaired. During the period from 1998 through 2016, defaulting loans recovered 66% of their value while bonds recovered 40%. [0] 3. CLOs generally made it through 2008/2009 without any major issues. The structures held up as designed, but prices fell along with other structured products since there were few buyers and many sellers. If you were able to hold, you did reasonably well. Over the 20 year period from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted (no AAA or AA defaults) and had a 0.04% loss rate. [1] 4. What has changed since 2008 is that loans are becoming a larger portion of the total value of the business (loan-to-value). This means that if the business goes bad, there's less of a cushion for the loan and recovery rates will be lower. I don't know how much lower, but some of the junior tranches in a CLO could be impaired in a severe downturn. It's hard to really know, but I _think_ things would need to be worse than 2008 (or the same level of crisis, for a longer period) for AAA tranches in general to be permanently impaired. 5. Accounting plays a role here. If you are required to mark-to-market, then the market clearing price is what the asset is worth, regardless of fundamentals. If there's a panic, you may be a forced seller if you don't have sufficient reserves to get through the disruption and your mark-to-market loss becomes a permanent loss. This applies to any asset class, not just structured products. 6. I don't understand why the article brings up CDS gaming. It's a real issue, and one that is being worked on, but it's not even a rounding error compared to the size of the corporate debt universe. [2] quote from the FT article: "Isda’s method of “fixing” CDS has always been akin to “patching” software after hackers exposed weak points. When one window closes, traders simply find a new one." [0] "JPMorgan Default Monitor 4Q16" [1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013” [2] https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32aece https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32a...

lefstathiou 8y ago

CLOs are comprised of loans made to small businesses. Small businesses are inherently risky. CLOs exist because they are a relatively inexpensive form of long term funding. Let’s ponder the type of people who start and operate small businesses and whether or not they get access to competitive bank financing... Once upon a time, seeing entities willing to write loans to small business was worth celebrating. Amusing that once we find out it’s Wall Street stepping in to facilitate this at a scale the government cannot, it is dangerous gambling.

kgwgk 8y ago
I don’t know what’s the definition of “small business”, but the size of these loans is typically tens or hundreds of millions.
- w4 8y ago
  The definition of "small business" varies a lot. You probably think of a locally owned dry cleaner or coffee shop when you hear the term "small business." I know that's what I think of when I hear the term. But in the context of lending, the definition of "small business" (usually lumped together with mid-sized businesses under the umbrella term "SMBs") is usually something like <$50MM in annual revenue, or <100 to <500 employees, depending on who you're talking to. They can be quite large compared to what most people think of when they hear "small business," but they're small when compared to large enterprises. This categorization speaks less to the size of the businesses themselves, and more to the scales that these banks operate on. After all, $50MM annual revenue or 500 employees seems pretty darn big to me!
marcosdumay 8y ago
There is absolutely no problem in making risky loans. But there are many problems with packaging those loans together and selling them to a third party that can't calculate its risk level claiming it's low risk.
- lefstathiou 8y ago
  An important clarification here: CLOs are sold to multi billion dollar asset managers (technically referred to as QIBs, entities that manage at least $100mm in Assets Under Management or more - the vast majority of the structured products business is dominated by large fund managers). It is the highest tier of investor "suitability" recognized by the SEC. It's their job to understand these products and they have armies of people for it. It can take weeks to "market" these transactions and plenty of opportunities to sit down with bankers and CLO managers to get smart on the space. There is also a ton of supporting technology and research, all of which is available for free on S&P, Moody's, Fitch, Kroll and Morninstar's websites. If you cannot sell this stuff to a QIB, who can you sell it to?

ikeboy 8y ago

The article is conflating two distinct issues - CDS warping incentives, and CLOs. CDS is primarily relevant to bonds that trade on the open market. CLOs are packaging private loans made by banks, not bonds. To treat them as relevant to each other demonstrates the author has no clue what they are talking about.

mlevental 8y ago
>By William D. Cohan https://williamcohan.com/about/ https://williamcohan.com/about/ who shall i believe? you or him?
- ikeboy 8y ago
  Don't know what to say then. Maybe the editor insisted this crap be included?

redwood 8y ago

What's the relative size of this market, particularly the high-risk segment in comparison to the size of the subprime mortgage segment and associated CDOs in the 2008 crisis? Without a sense for whether the order of magnitude is similar, it's hard to draw conclusions on the level of systematic risk.

ddoolin 8y ago
The article says that leveraged corporate loans make up about $1.2T. Wikipedia says the subprime mortgage market was around $1.3T in March 2007. https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subprime_mortgage_market https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subpr...
- redwood 8y ago
  Wow thanks. That certainly makes things more acute! I suppose businesses are structurally different from home buyers in a number of ways: for example when a business goes bankrupt (correct me if I'm wrong) creditors are paid out to the extent they can be. Whereas when a home owner goes bankrupt I believe they can get out of their obligations entirely.

b0bby_tabl3s 8y ago

The ole' shell game.

nimbius 8y ago

I see a lot of comments in the article on how this is just a scare piece, but it bears remembering just how big of a crisis the 2008 financial collapse was. Stagnant wages in the 90s gave rise to credit cards and personal debt-as-a-feature capitalism, which was immediately blown out of the water by 2008. people lost their homes because the credit system keeping them afloat basically collapsed. businesses started shedding employees and shuttering doors, while banks across the world began a series of spectacular failures. Not just banks and auto makers, but capitalism itself looked to be slowly collapsing under its own weight of the hubris of mankind. Its really stunning to look back at some of the absolutely bombastic thing we said and did in the service of not people who were displaced and destitute after this collapse, but in the service of trying to keep capitalism going for ten more years. At some point we started bribing people to participate in the market that just made them homeless with "cash for clunkers." This was an asinine program designed to "boost the economy" by paying people to destroy their already running vehicles under the guise that they caused too much pollution. This didnt work. It could never work, and so we switched tactics toward simply bailing banks and auto manufacturers by cutting trillion dollar checks and printing more cash. Nobody who caused the financial collapse was ever arrested, save perhaps Bernie Madoff for his high treason of swindling the plutocracy. At the last few months of the term of George W Bush, a round of "stimulus checks" were cut and sent back to americans. The idea here was that americans would buy new televisions and sneakers. The reality for many, including me, was that money went to savings or closing out credit card accounts we didnt need. And here we are, once again, at the brink of another 10 year cycle. Things seem fine but theres hand-wringing from the usual suspects about systems of credit and debt so complex they cannot possibly exist outside a PhD thesis.

ssrcity 8y ago

A major issue in 2008 were loans made with no credit standards and investors were being sold what they thought was AAA credit risk when in reality the borrowers behind the securities were people with little income make the mortgage payments they were obligated to. The article at hand does little to prove that a similar phenomenon is going on with corporate bonds. Would be interesting to know whether the corporates spoken about here are public or private companies since, if they are public, any going concern can easily be analyzed via a company’s SEC filings. There’s no doubt that the structure of this product is similar to products which caused the financial collapse, but are all the other systemic issues present? I don’t think the author addresses that.

asabjorn 8y ago

If you put this is context of long-term economic stagnation where the kind of predictable growth modernity brought over two hundred years is no longer there, then for people that are expected to generate large returns have a large incentive to take on riskier investments that might give an growth upside. Eric Weinstein argues [1] that what we are experiencing is a long-term stagnation of western economy, and arguably any economy that is not catching up. This is in his estimation the cause of many of our issues. [1] https://www.youtube.com/watch?v=TKeMIWVOnbo https://www.youtube.com/watch?v=TKeMIWVOnbo

4RealFreedom 8y ago

A lot of good comments. I just wanted to point out that the last line in this article states 'Why do investors fail to learn the harsh lessons about risk, even though the consequences of them still remain so fresh?' Speaking about the past market problems, if no one is held accountable why should change occur?

michaelmrose 8y ago
At the top where it matters they don't experience as many negative consequences long term as middle class and down. If they lose half their wealth they don't buy a new boat this year.

zelon88 8y ago

Here's a heartwarming tale of a man who got a call from a debt collector with a fake note threatening to rape his wife. It started his years-long crusade to bring down the loan sharks responsible for selling fake debt with his name on it..... https://www.bloomberg.com/news/features/2017-12-06/millions-are-hounded-for-debt-they-don-t-owe-one-victim-fought-back-with-a-vengeance https://www.bloomberg.com/news/features/2017-12-06/millions-...

m101 8y ago

There are a number of errors in this article, and there are important things that articles like this fail to mention: - the loans aren't made by the banks and then shifted, they are more often sold to investors without the bank assuming any of the loan themselves (it's called loan syndication). The bank simply acts as the role of arranger. - the Japanese investor base is mostly in the most senior part of the capital structure - for similar credit ratings CLOs have far lower default rates than for equivalent corporates. It's something like 2-3% in the B and BB rated tranches through the crisis - the average piece of CLO equity returned something like mid-single % digit returns if held through the whole of the financial crisis - the paragraph on credit default swaps is a distraction. No CLOs use credit default swaps, and certainly no one sells credit default swaps which reference CLO tranches. This happened prior to the financial crisis through synthetic-CLOs but these don't exist anymore. Sometimes investors in CLOs use credit default swaps against an index of credits (like XOVER for instance), but this doesn't really work as a CLO hedge The facts are that many lessons have been learned since the crisis and people aren't doing the same things they did back then. What can be said is that there is a race to the bottom in terms of loan covenants diminishing, but this is driven by larger demand for loans than supply resulting in borrowers achieving looser document terms. The drivers of this are often the law firms that work on behalf of the borrowers who promise being able to achieve looser and looser language with a view to winning the business. Unfortunately the lenders have a weak hand in this situation as they are many chasing few assets and find it difficult as individual institutions against a syndicating bank and borrower who have full information and can play lenders off against each other.