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Maybe someone that understands this better than I do can comment, but isn't this something that can lead to CLO collapse and systemic financial system failure (

Maybe someone that understands this better than I do can comment, but isn't this something that can lead to CLO collapse and systemic financial system failure (similar to 2008, but maybe not as severe?). Described in this: https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/ https://www.theatlantic.com/magazine/archive/2020/07/coronav... The Dodd-Frank act capital requirements seems like they'll protect banks a bit, but to an outside layman like me it does seem like the CLO risk is similar in structure to CDOs. What am I missing?

thoughtstheseus 6y ago
Banks don’t own much of CLOs compared to other market participants, banks have much more stable and safe assets across the board, the borrowers are not individuals with mortgages but companies with diverse capital structures and interests. They are similar to CDOs and there are certainly those taking too much risk in the CLO market. The Fed brought up this issue before the pandemic and no one seemed to care...
- fossuser 6y ago
  > "the borrowers are not individuals with mortgages but companies with diverse capital structures and interests" I'd be skeptical how different this is in practice. In 2008 there was an incentive to give loans to people without caring if they could pay because you could immediately sell them to larger banks that never checked the underlying status of the borrower. With CLOs the borrowers are already selected to be companies in trouble - is the underlying resell incentive fixed if they're still being bundled together? In some ways the selection is worse because while most people need a mortgage no matter how good their credit is, I think business loans are needed more by desperate businesses. At least if the banks don't own as much (like you said) that's probably good. From that Atlantic article: > "A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world." I think the structure of the CLO tranches rely on not all small loans collapsing at once and I'd bet the banks risk models (which already are incentivized towards taking on too much risk) didn't account for a global pandemic forcing everyone to stay at home. I know Dodd-Frank requires them to have lots of capital on hand to protect against this kind of problem, but is it enough? Also for us regular people, what should we be doing? Sell index funds and just buy Amazon? Again, from that Atlantic article: > "For the moment, the financial system seems relatively stable. Banks can still pay their debts and pass their regulatory capital tests. But recall that the previous crash took more than a year to unfold. The present is analogous not to the fall of 2008, when the U.S. was in full-blown crisis, but to the summer of 2007, when some securities were going underwater but no one yet knew what the upshot would be." I don’t work in finance and these topics always bring out over confident know-nothings on HN going on about policies they don't understand (and I don't want to be that), but there are parallels here that seem pretty disturbing. I don't want to be in the Summer of 2007, our institutions are less stable than they were back then and the politics have gotten scarier.
vkou 6y ago
It can lead to something like that, yes. Like in 2008, the Fed will print as much money as it takes to prevent this kind of systemic collapse.
- fossuser 6y ago
  We were lucky in 2008 that there was the political will and capacity for Congress (and the incoming Obama administration) to do what they did. I think whatever people thought of the decisions at the time, the market recovery after 2008 (and all of the banks paying back those loans) is evidence that those decisions were right. I'd be worried that the political will may not exist this time, or that the administration wouldn't be able to understand the problem well enough to even figure out what should be done.
  - vkou 6y ago
    The Fed has reacted in pretty much the same manner in 2020 as it did in 2008.

thoughtstheseus 6y ago

Banks don’t own much of CLOs compared to other market participants, banks have much more stable and safe assets across the board, the borrowers are not individuals with mortgages but companies with diverse capital structures and interests. They are similar to CDOs and there are certainly those taking too much risk in the CLO market. The Fed brought up this issue before the pandemic and no one seemed to care...

fossuser 6y ago
> "the borrowers are not individuals with mortgages but companies with diverse capital structures and interests" I'd be skeptical how different this is in practice. In 2008 there was an incentive to give loans to people without caring if they could pay because you could immediately sell them to larger banks that never checked the underlying status of the borrower. With CLOs the borrowers are already selected to be companies in trouble - is the underlying resell incentive fixed if they're still being bundled together? In some ways the selection is worse because while most people need a mortgage no matter how good their credit is, I think business loans are needed more by desperate businesses. At least if the banks don't own as much (like you said) that's probably good. From that Atlantic article: > "A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world." I think the structure of the CLO tranches rely on not all small loans collapsing at once and I'd bet the banks risk models (which already are incentivized towards taking on too much risk) didn't account for a global pandemic forcing everyone to stay at home. I know Dodd-Frank requires them to have lots of capital on hand to protect against this kind of problem, but is it enough? Also for us regular people, what should we be doing? Sell index funds and just buy Amazon? Again, from that Atlantic article: > "For the moment, the financial system seems relatively stable. Banks can still pay their debts and pass their regulatory capital tests. But recall that the previous crash took more than a year to unfold. The present is analogous not to the fall of 2008, when the U.S. was in full-blown crisis, but to the summer of 2007, when some securities were going underwater but no one yet knew what the upshot would be." I don’t work in finance and these topics always bring out over confident know-nothings on HN going on about policies they don't understand (and I don't want to be that), but there are parallels here that seem pretty disturbing. I don't want to be in the Summer of 2007, our institutions are less stable than they were back then and the politics have gotten scarier.

vkou 6y ago

It can lead to something like that, yes. Like in 2008, the Fed will print as much money as it takes to prevent this kind of systemic collapse.

fossuser 6y ago
We were lucky in 2008 that there was the political will and capacity for Congress (and the incoming Obama administration) to do what they did. I think whatever people thought of the decisions at the time, the market recovery after 2008 (and all of the banks paying back those loans) is evidence that those decisions were right. I'd be worried that the political will may not exist this time, or that the administration wouldn't be able to understand the problem well enough to even figure out what should be done.
- vkou 6y ago
  The Fed has reacted in pretty much the same manner in 2020 as it did in 2008.