Author Topic: Will the banks collapse? (The Atlantic article about issues with the CLO market)  (Read 2309 times)

thedigitalone

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Clickbait title aside, I didn't know that the CLO market was so.... interesting.

https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/


Optimiser

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In case you don't want to click the link:

Quote from: The Atlantic
the CLO, or collateralized loan obligation. 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. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.

Tyler durden

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Saw this article today and really wanted to read it. Was hoping someone was going to say it was a waste of time so I could skip it. Guess ill go read it now.

Before I dig into it though I would say banks are much better regulated after the Dodd Frank act but ill give the article a look to see what their take is.

Travis

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I think I already saw this movie.

ChpBstrd

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Great information, but the editor wrapped it up in a package of doom, damaging its readability and perceived credibility.

I'm counting on a bank blowup. CLO's are only part of the story. Regular corporate bonds are going to see lots of downgrades and defaults. Then there are mortgages, again. When mortgages or corporate bonds yield only, say, 3.5% there is not much room for foreclosures or defaults until the yield on the packaged security goes negative. 10% unemployment for a year can be expected to do exactly this. Finally, small business and consumer loans are not even being talked about like they might go bad. COF stock is booming.

As the author points out, a wave of defaults could take a year or longer to play out and affect the stock market. This is why Powell was comfortable saying we will have 0% interest rates until 2022. He knows many banks and insurance companies might be mortally wounded. Yet stocks could boom for the next several months even as a financial crisis cooks, propped up by the Powell Put and actual asset purchases. In 2008, the Fed wasn't purchasing assets until it was far too late.

Another way "this time is different" than 2008 is the speed and volume of helicopter money being dropped. The question is whether billions in helicopter money and the spending it stimulates will be enough to offset financial institutions' losses on loans. I also get the sense Powell is copying the plan from 2008, and due to experience will be quicker to recognize seizing markets and teetering big banks. Maybe this time the Fed puts out the fire before it escapes the kitchen. In fact, it's hard to imagine the Fed not running the exact same playbook of everything that worked in 2008, but much more quickly.

On the flip side, experienced investors now know that sketchy shit non-investment-grade debt is buried and obscured in every financial stock's balance sheet. It's the only way banks produced cash flow in our low-interest rate era. They may be more inclined to sell earlier in the process rather than being surprised as they were in 2008.

I'm considering a "cash and calls" strategy, index fund collars, or a bear spread on financials vs. the rest of the market. I.e. things with limited risk and solid potential returns if the doom articles are wrong.

MyOtherBrotherDarryl

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Thanks for sharing this article.

I think I already saw this movie.

That movie... was it big and short?

Travis

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Thanks for sharing this article.

I think I already saw this movie.

That movie... was it big and short?

If what this article predicts comes true, then the movie will have to change its name since it won't be THE big short anymore.

Also, we know how things turned out for those banks.

ChpBstrd

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Thanks for sharing this article.

I think I already saw this movie.

That movie... was it big and short?

If what this article predicts comes true, then the movie will have to change its name since it won't be THE big short anymore.

Also, we know how things turned out for those banks.

Hollywood loves a sequel, but investors might poo their pants.

ctuser1

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What the author writes is possible, but very very very unlikely.

Quote
But in December, the Financial Stability Board estimated that, for the 30 “global systemically important banks,” the average exposure to leveraged loans and CLOs was roughly 60 percent of capital on hand.

So, the *exposure* is 60% of the capital in hand. To put the number in context, the big banks currently operate with 8X leverage at a minimum. i.e. the well capitalized banks carry 800% exposure of the "Capital in hand" to all "Risk Weighted Assets". Before 2008, banks would sometimes go up to 30X+ leverage.

So the 60% number is peanuts, once you gain some perspective of what Fractional Reserve banking means, and has meant for 100+ years.

Add to that,  a lot of that exposure will likely be backed by some form of collateral. The collateral rules (terminology you can look up are IM=Initial Margin, VM=Variation Margin, UMR=Uncleared Margin Rules) have been significantly strengthened since 2008, AND additional layers of safety in the form of different types of VA's (VA=Valuation Adjustment, think of them as internal insurance mechanism inside the big banks) have been beefed up and strengthened. So any systemic issue will have to breach several such layers of protection before it becomes a systemic crises.

Banks making huge losses for 2-3 years is likely. Complete collapse seems unlikely to me.

Now, banks operate on confidence and faith that people put on them AND the financial system backed by sovereign entities. If that goes, the banks will likely collapse irrespective of whatever collateral, VAs etc you may have on the book. Can that confidence evaporate for some reason? It's possible. However, I'd argue it is far less likely to happen right now than in 2008. 20 years later, once all the people with memories and lesson learned from 2008 retire - maybe the possibility will increase back up again. Nor right now.

-------------------

The above is not to say everything is hunky dory. Several layers of redundancies in the in the Valuation Adjustment and Collateral calculations have been stripped off in the last 3-4 years. Individually, they don't make much difference. Together, they make the system a little bit weaker - which I am not a big fan of.

Hopefully the regulators will start becoming more stringent again after this crisis AND hopefully that will be facilitated by a change in political wind away from the proponents of the billionaire-wing economics (as opposed to left-wing or right-wing).

PDXTabs

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Banks making huge losses for 2-3 years is likely. Complete collapse seems unlikely to me.

Huge losses could still be huge. Also, aren't a bunch of these CLOs owned by pensions and insurance companies? I probably worry about the insurance companies the most.

Buffaloski Boris

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Meh.  The article is focusing on the banks while ignoring the elephant in the room: American companies are leveraged to the hilt.  We've seen in the past few months that the Fed is ready, willing, and able to do anything it can to backstop corporate debt.  So I'd be less concerned about the collapse of the debt; the Fed is going to dive in to buy it.  What I'd be concerned about is the dollar.  Being the reserve currency allows the Fed to be profligate, but only to a point. Once that point is crossed and folks start deciding that being long dollars is a bad idea, then things get very interesting.   

Travis

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Meh.  The article is focusing on the banks while ignoring the elephant in the room: American companies are leveraged to the hilt.  We've seen in the past few months that the Fed is ready, willing, and able to do anything it can to backstop corporate debt.  So I'd be less concerned about the collapse of the debt; the Fed is going to dive in to buy it.  What I'd be concerned about is the dollar.  Being the reserve currency allows the Fed to be profligate, but only to a point. Once that point is crossed and folks start deciding that being long dollars is a bad idea, then things get very interesting.

Uncle Sam took care of the banks last go-round. What lessons did they learn in 2008? What incentive do they have for behaving more responsibly?

ctuser1

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Uncle Sam took care of the banks last go-round. What lessons did they learn in 2008? What incentive do they have for behaving more responsibly?

They were made to do a lot of stuff by Dodd-Frank and Basel III, and pretty stringent regulators. Generally, a lot of loose ends were tightened around how risk was measured, capital requirements raised, eliminated prop trading, off-balance-sheet bs etc. etc. etc.

The rules were gradually phased in, and the most stringent rules were set to start from 2019 and 2020.

Of course, come 2016 and that push was set to reverse, and those requirements started loosening up.

e.g. https://www.bis.org/publ/bcbs279.pdf -> A standardized way to measure counterparty risk was supposed to come live for all 29 Global SIBs (Systemically Important Banks).

Well, they no longer have to do this. They can simply get exceptions to continue using the older, looser standards that allow for more games to be played.

« Last Edit: June 11, 2020, 08:27:41 PM by ctuser1 »

theolympians

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No, they won't. I saw an article a couple months ago reading that QE would continue for the foreseeable future. The banks will continue to get money for the gov't. The gov't learned its lesson from 2008.

MustacheAndaHalf

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My understanding is that in 2008, CDOs needed stealth and size to cause damage.  The regulators had to be unaware of them, and they had to be big enough to bring down the financial system.

It looks like the Fed is tracking CLOs.  For example, it has specific rules about how CLOs are treated in it's "Term Asset‐Backed Securities Loan Facility" program.
https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200512a1.pdf

In this update from the end of May, CLOs also appear several times:
https://www.federalreserve.gov/files/pmccf-smccf-talf-5-29-20.pdf

There doesn't seem to be enough size and surprise here for CLOs to melt things down.

BicycleB

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This is just the reasoned discussion I was looking for. Thanks, gang.

Paul der Krake

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grettman

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All I need to know about this article is that it was published in "The Atlantic".


UnleashHell

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All I need to know about this article is that it was published in "The Atlantic".

too many words for you?

ender

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Debunked: https://nathantankus.substack.com/p/is-there-really-a-looming-bank-collapse

Nice, this is basically what I thought when I previously read that article (and consequentially assumed it was hyperbolic fear mongering).

Quote
Professor Partnoy relies on our inherent fear of large numbers to paper over the thinness of this claim. Returning to the OCC report, we find out that Wells Fargo has more than 1.7 trillion dollars in assets. 29.7 billion is about 1.7% of Wells Fargo assets. CLOs are similarly minor for the other large banks

Numbers without context are scary.

Add context? Most of the teeth of the "bank collapse" fear mongering goes away.

grettman

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All I need to know about this article is that it was published in "The Atlantic".

too many words for you?

Ah!  A fan boy!

ChpBstrd

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The precise instrument that blows up the financial industry is no more clear now than it was in 2006 or 2007. Maybe it’ll be some derivative, maybe mortgages again, or maybe plain vanilla corporate bonds. CLO’s could be just one if many bombs.

It’s the differences with 2008 that disturbed me. Back then we had just two problems: high oil prices and higher-than-projected foreclosures. In 2020, on the other hand, we went from <4% unemployment to about 20% overnight, consumer demand crashed, missed rents and foreclosures are heading towards records, small businesses are failing at historic rates, record corporate debts + sudden loss of demand, and on top of all that a couple MILLION Americans got sick within a span of a couple of months, devastating productivity. The 2020 backdrop includes overpriced housing in coastal/urban areas as it did in 2008, but also record corporate/government leverage and a pre-existing deflationary undertow. All this is offset to an unknown extent by government stimulus that was bigger and faster than in 2008, but little of this was directly for purposes of propping up banks.

There’s no reason multiple areas of debt couldn’t default all at once. Maybe it will be car loans + subprime mortgages + small business loans. Maybe it will be corporate debt + mortgages. Maybe a couple of A-rated sovereign states default, oil industry debt, and student loans go unpaid. Maybe the currencies of Russia, Brazil, and Turkey collapse. A failure of retail or apartment REITs would surprise everyone. Then there are CLOs, swaps, and derivatives. Any of these could cause a banking crisis somewhere, and what we should know by now about banking crises is that they tend to spread. After all subprime defaults seemed like a manageable problem in late 2007.

ctuser1

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The precise instrument that blows up the financial industry is no more clear now than it was in 2006 or 2007. Maybe it’ll be some derivative, maybe mortgages again, or maybe plain vanilla corporate bonds. CLO’s could be just one if many bombs.

It’s the differences with 2008 that disturbed me. Back then we had just two problems: high oil prices and higher-than-projected foreclosures. In 2020, on the other hand, we went from <4% unemployment to about 20% overnight, consumer demand crashed, missed rents and foreclosures are heading towards records, small businesses are failing at historic rates, record corporate debts + sudden loss of demand, and on top of all that a couple MILLION Americans got sick within a span of a couple of months, devastating productivity. The 2020 backdrop includes overpriced housing in coastal/urban areas as it did in 2008, but also record corporate/government leverage and a pre-existing deflationary undertow. All this is offset to an unknown extent by government stimulus that was bigger and faster than in 2008, but little of this was directly for purposes of propping up banks.

There’s no reason multiple areas of debt couldn’t default all at once. Maybe it will be car loans + subprime mortgages + small business loans. Maybe it will be corporate debt + mortgages. Maybe a couple of A-rated sovereign states default, oil industry debt, and student loans go unpaid. Maybe the currencies of Russia, Brazil, and Turkey collapse. A failure of retail or apartment REITs would surprise everyone. Then there are CLOs, swaps, and derivatives. Any of these could cause a banking crisis somewhere, and what we should know by now about banking crises is that they tend to spread. After all subprime defaults seemed like a manageable problem in late 2007.

CCAR scenarios that banks run every year take the simultaneous turmoil in all Markets into account. In fact, these are the focal point.
So coordinated blowups in all the "known" risk factors alone should not sink the banks.

What was different in 2008? Well, banks back then had no effective restrictions against prop trading and off-balance sheet entities. So a lot of risks were not under the radar of the regulators and were not being "managed". If you remember, all the actual blowups were in either such off balance sheet BS, or in non-banking entities that were not uniformly regulated as banks. e.g.
1. Lehman (https://www.businessinsider.com/report-lehman-brothers-used-accounting-gimmick-to-hide-the-size-of-its-balance-sheet-2010-3)
2. AIG
etc. etc.

Short of blatantly criminal fraud (which is unlikely to pay, because compensations is also reviewed by regulators) at the top in the large banks - that should no longer be the case today.

If banks are to sink, it has to be something nobody is expecting, and is not modeled or risk managed. Anything that is in anybody's radar is risk managed and appropriate buffers been put in place.

This is not new. Big systemic issues are generally not caused by things everybody is expecting.

FiveSigmas

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Debunked: https://nathantankus.substack.com/p/is-there-really-a-looming-bank-collapse

Thanks, that was illuminating. Out of curiosity, is this a blog that you follow regularly?

Paul der Krake

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