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When to be afraid

The Bank of England was peeping out in the latest report from its Financial Policy Committee, whose job is to seek out and destroy would-be threats to the UK’s financial system. Doing likewise is Janet Yellen, until early this year the risk-buster-in-chief of the Federal Reserve, the US central bank, who reckons the finance industry is close to forgetting the lessons of the 2008 crash.

In the UK and especially in the US, the Bank of England worries about the rapid growth of so-called ‘leveraged’ loans, which are arranged by syndicates of bankers with the prime aim of bundling them into securities and selling them to the shadow banking system (ie investors of some sort). In 2017, non-finance UK companies raised £38bn via such loans – then a record annual tally – and in the first nine months of 2018 a further £30bn has been raised. Taken together, leveraged loans and their close cousin, high-yield (or ‘junk’) bonds, now account for 20 per cent of all UK company borrowing, the bank reckons.

In the US, where financial innovation almost always leads the world, the leverage has been ratcheted up a notch or two. The UK central bank says that gross debt of US companies has risen to almost three times their annual profits, close to the levels hit shortly before the 2008 crisis. Meanwhile, the stock of leveraged loans has topped $1 trillion, or 12 per cent of all corporate debt.

No problem, say those doing nicely out of arranging, issuing and repackaging collateralised loan obligations. Sure, CLOs may have characteristics that are as close to CDOs as their acronym, but in key respects they claim to be very different. In a way, they should be securitised debt for adults. That’s because they are mostly backed by loans made to companies owned by private equity, which should have a vested interest in ensuring that their firms perform.

Ostensible proof is there; at least, the record of CLOs seems sound. According to data from credit rating agency Moody’s, default rates on leverage loans peaked at 10 per cent in late 2009, since when they have slid to less than 2 per cent. Meanwhile, returns on the equity tranches (ie the riskiest slice) of CLOs that were issued in 2005-07 – immediately before the financial crisis – have averaged 9 per cent a year since then. Defaults on debt tranches rated A or above have been pretty well non-existent.

Besides, in one important respect CLOs are simpler than CDOs – they can’t be put into default by the effect of mark-to-market accounting on the value of their collateral. All that really matters is the cash flow from the interest payments on the underlying loans. So long as that filters through – starting at the AAA-rated tranche and seeping down – then all is well. If individual loans within a CLO go into default then the riskiest tranches get hit but the integrity of the CLO, in theory, remains intact.

Except that similar arguments about the wonders of diversification used to be advanced in favour of CDOs. And in February arguably the major stabiliser in favour of CLOs was removed. This was the skin-in-the-game rule that required CLO managers to keep 5 per cent of any CLO that they arranged. But managers – usually banks – have not been forced to eat their own cooking since a US court of appeal decided that the so-called risk-retention rule need no longer apply.

Where liberalisation leads, excess often follows and it may be no coincidence that the Bank of England is concerned that the equivalent of ‘liar loans’, which helped corrupt the CDO market in the mid 2000s, is seeping into CLOs. Increasingly, highly indebted borrowers are lying about their true debt-to-profits ratio; at least offenders are inflating their profits – and thereby lowering their leverage – by assuming that the gains from slated cost-cutting have already come through. Combining that with a trend towards weaker loan covenants, which give lenders less protection, makes for an eerie feeling.

True, the bank also acknowledges important differences between CDOs and CLOs; in particular, that the debt behind CLOs does not rely on being rolled over in the short-term money markets as did much of the CDO market at its craziest. And so far there is little sign of the insanity that inspired so-called CDO-squared and CDO-cubed, where synthetic CDOs were created to bet on the performance of CDOs that actually owned some debt. That said, there are US listed exchange traded funds that track indices of leveraged loans, which might be the first symptom of madness.

Happily, so far these funds deal in real loans. When that changes; when CLO-squared slithers from the slime it will be time to change the movie metaphor. Forget about the hideous amphibian and fast-forward 30 years to the re-make of The Fly, whose famous epithet was “be afraid; be very afraid”.