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Collateralized loan obligations: Our next financial nightmare

April 10, 2014: 5:00 AM ET

Greed, stupidity, and slack government oversight fueled the mortgage bubble. The same thing seems to be happening today, but this time with leveraged loans and junk bonds.

By Cyrus Sanati

Janet Yellen, chair of the U.S. Federal Reserve

Janet Yellen, chair of the U.S. Federal Reserve

FORTUNE -- The growing leveraged loan bubble received a big boost of hot air this week thanks to Wall Street's "friends" down in Washington.

The Federal Reserve, under intense pressure from members of Congress (on both sides of the aisle), said in a short statement Monday that it was extending the deadline for banks to comply with key aspects of the so-called "Volcker Rule," the new government regulation that aims to curb excess risk-taking by financial institutions. This delay will allow banks to continue supporting what has become a very frothy corporate debt market, increasing the risk of another 2008-like cataclysmic financial event.

Remember all those "complex" financial instruments that exploded in 2008 -- the ones that brought the economy to its knees? I am talking about the securitized alphabet soup of debt instruments, like MBS, ABS, CDO, CDS, etc. Well, they never went away.

One in particular, though, has come back in a big way -- collateralized loan obligations, or CLOs.

For a quick refresher, a CLO is a type of debt security made up of several high-risk commercial loans, which have been bundled together and sliced into tiny, bite-size pieces for sale to investors. Some of the pieces carry more of the loans' investment risk than others. Investors who choose to buy a higher risk (lower rated) piece enjoy a larger return on their investment than those who choose to buy a lower risk (higher rated) piece. But if some of the loans start to default, the lower rated pieces absorb the brunt of the losses while the higher rated pieces enjoy a consistent return.

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Sound familiar? CLOs are pretty much like the CDOs (collateralized debt obligations) that imploded so spectacularly during the 2008 meltdown, but instead of being chock full of bad mortgages, CLOs are filled to the brim with junky leveraged loans. A leveraged loan is a loan issued by a bank to a firm that already has a lot of debt on their books and thus has a lower credit rating.

CLOs didn't implode as badly as their CDO counterparts, so investors have gravitated to them over the last two years as a way to achieve outsize returns with no measurable increase in risk. A whopping $83 billion worth of CLOs were issued in 2013, a remarkable comeback from the $3 billion issued in 2009.

Investors say they are drawn to CLOs because they offer relatively high returns at the same risk level as a U.S. Treasury bond. Why do they think this? Well, because the rating agencies and banks say so. The typical CLO may be made up of a bunch of leveraged, high-risk loans, but around 65% of the pieces sold off to investors are rated as AAA. That is down from 2007, when 75% were rated AAA, but it is still a, well, curiously high percentage. Bankers who issue these loans say that things have changed. "These are CLOs 2.0 -- they are totally different," one told Fortune, with a chuckle.

Bank advocates claim that CLOs 2.0 are far safer than their pre-crisis counterparts, and you can see it by the sheer amount of CLOs that the banks are choosing to hang on to rather than sell to other investors. Indeed, around $70 billion of the $300 billion worth of CLOs on the market today are supposedly held by the banks. Clearly, the banks wouldn't be holding on to stuff that was unsafe, right?

Wrong. Banks held on to a lot of mortgage-backed securities during the credit crisis as well. They did so because they couldn't find buyers for the stuff or they were drinking their own Kool-Aid. After all, a banker doing deals is in it to win it -- for themselves. Due to the bonus structure, bankers are incentivized to produce revenue by any means necessary. The bank? Who cares about them? Companies with plenty of debt operating in a lackluster economy aren't safe investments. If the economy turns -- boom, game over.

The only way to prevent the CLO market from going the way of the CDO market is to reduce investor demand for them before it's too late (assuming that it isn't too late already). Luckily, many of the CLOs issued so far have been refinancing of existing loans. But new ones – junkier ones – are being issued at a healthy clip.

There's pretty much only two ways to curtail demand here. Either the Fed will need to raise interest rates to decrease the spread on CLO yields (making them less attractive for investors seeking high returns) or the government will have to force the banks to stop issuing and supporting them.

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Getting the Fed to raise interest rates is pretty much impossible -- they seem set on continuing a low interest, bubble-inducing monetary policy, indefinitely. But the banks can be cut off from the market pretty easily -- indeed, it already is the law.

The Volcker Rule, which is part of the Dodd-Frank financial reform act, says, among other things, that banks cannot have an "ownership stake" in certain risky assets and investments. CLOs are clearly debt instruments, but since they are actively managed, investors can do a lot of "equity-like" things, such as firing their investment managers or issuing bonds. The government says these powers demonstrate an ownership stake, thus placing CLOs under the Volcker umbrella of banned investments.

But with Volcker set to go into force (officially) in July 2015, banks would not only have to stop creating CLOs now, they would also need to quickly sell off investments they have accumulated. Banks claim they are simply not ready to comply with the rule (despite the fact that Dodd-Frank came into force around four years ago) as it would force them to chuck their CLOs in a mad fire sale, which would be disastrous for asset prices.

With the Fed standing firm, the banks have turned to Congress for some help. The Republican-led House Financial Services Committee met to discuss the issue in February and heard from such, ahem, balanced witnesses like the U.S. Chamber of Commerce, who argued that shutting down the CLO market would create financial bedlam.

On March 14, the committee overwhelmingly cleared a bill, on a bipartisan vote of 53 to 3, that would essentially make it easier for banks to issue CLOs under Volcker. It also grandfathered CLOs created before February 2014 from complying with Volcker completely. It's a long way from becoming law, and it could change significantly before it hits the floor for a full vote, but who could vote against a bill entitled the "Restoring Proven Financing for American Employers Act"?

This leads us back to the Fed's CLO-friendly actions this week. Clearly, they were feeling the heat from Congress on this one. The two one-year extensions now gives the banks until July 2017 to sort out their CLO issues. Chances are the banks will never have to adhere to those restrictions unless CLOs start to blow up.

The banks don't seem too concerned, though. CLO issuance in March reached $10.8 billion, the highest month ever since May 2007, right before the credit crunch began. The banks know that if the Fed doesn't acquiesce, it can always get Congress to back them up.

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Greed, stupidity, and slack government oversight fueled the mortgage bubble. The same thing seems to be happening today, but this time with leveraged loans and junk bonds. While bankruptcies and defaults are very low today, that won't always be the case, especially if there is another credit crunch.

CLOs are illiquid, meaning that if things get tough, there is no easy way for a bank to unload them. Such illiquid investments could spell disaster for a bank in desperate need of cash -- remember Bear Stearns and Lehman Brothers? This is what needs to keep Janet Yellen, the new head of the Federal Reserve, up at night. But, unfortunately, it seems she is sleeping quite soundly.

UPDATE: An earlier version of the article stated that for the last 94 weeks, there has been a positive inflow of cash into the CLO market. This is incorrect. The inflow was referencing the cash entering the leverage loan asset class through US loan funds, not the CLO market. The sentence has been removed.

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