That’s the Whole Point

By James Kwak

The Wall Street Journal reports that the federal financial regulators may yet again carve a  loophole in the Volcker Rule. This time, the issue is whether banks subject to the rule’s proprietary trading prohibitions can hold collateralized loan obligations (CLOs)—structured products engineered out of commercial loans, just like good old collateralized debt obligations were engineered out of residential mortgage-backed securities during the last boom.

The reason to prohibit positions in CLOs obvious: it was portfolios of similarly complex, opaque, risky, and illiquid securities that torpedoed Bear Stearns, Lehman, Citigroup, and other megabanks during the financial crisis. The counterargument is one we’ve heard many times before: If banks are forced to sell their CLOs, they will have to do so at a discount, which will “have a material negative impact to our capital base,” in the words of one banker.

But think about it for a second. Why would selling CLO tranches reduce a bank’s capital? Capital is defined as assets minus liabilities; if you sell a CLO and get its value in cash, you have just exchanged one asset for another, and your capital is unchanged. The dirty not-so-secret is that the banks are afraid of having to sell their CLOs for less than the values at which they are carrying them on their balance sheets, which will reduce their capital (and, more importantly to their executives, their current-year accounting profits).

But this is one of the things that everyone should have learned back in 2008. If you sell something for less than its stated book value, it’s not the sale that’s making you economically worse off; it’s the fact that the thing is already worth less than you paid for it. If a bank is carrying a CLO at 100 cents on the dollar, and no hedge fund out there is willing to pay more than 90 cents, then it’s only worth 90 cents. The bank’s capital is already impaired; it’s just lying about it using accounting rules to avoid admitting it. If forcing banks to sell their CLOs is the only way to get them to recognize their actual value, then that’s a feature, not a bug.

Then the other argument is, you guessed it: prohibiting banks from holding CLOs tranches will reduce demand for the underlying loans, making it harder for companies to get credit. But again, that’s a good thing. Right now, banks are willing to overpay for CLOs (or, rather, they are unwilling to sell them for their actual market value, which amounts to the same thing in economic terms) because of accounting reasons. That means that we have too much demand for CLOs, which means we have too much credit. As we again should have learned in 2008, too much credit can be just as bad as—or sometimes much, much worse than—too little credit. It’s a distortion, and as any free market economist should tell you, getting rid of it is a good thing.

If CLO issuance is down, you can blame it, as Morgan Stanley does, on “regulatory uncertainty.” But what it really means is that the investors who only care about making money—such as hedge funds—don’t want to fund these loans, at least not at the terms on offer. That means that the economy will be better off if the loans do not happen. This is all the way things are supposed to be—except in that twisted fantasyland of bank lobbyists.

8 responses to “That’s the Whole Point

  1. We need to go back to Mayberry times when you went to get a loan at the bank. The bank would need collateral of at least as much as the monies you wanted. When Goober applied for a loan but had no collateral he replied ” So it sounds like you are telling me in order to qualify for a loan, I have to prove that I don’t need one”.
    In recent times any large corporation can get money, do what they want with it (package products), and if the math doesn’t work out int he long run, the Fed will come to the rescue with bailouts and zero percent interest loans to save face. This wont end well.

  2. There are no bad assets, only misunderstood assets. :-)

  3. It depends on the time frame they are given to comply. If it is short, the banks have a point, flooding the market would depress the market. As I don’t know the time frame they are being given nor have any idea of the market’s capacity to absorb the CLO’s, I’m not endorsing the bank’s position, just noting it is something to be considered.

  4. Glad to see you are back to more regular blogging.
    As a second to @Dustin, if the holders have to dump all at once, they’ll get fire-sale prices for the stuff. Potential buyers, knowing the fire sale is going to happen, will stay away until then.
    OTOH, the issuers, knowing they will have to compete against super-cheap prior issues on the resale market, will cut back on new issues (exactly as they are doing).
    Macroeconomic impact is likely to be small either way, as the CLO market’s best year (2012) was just $55B, a very thin slice of the total economy.

  5. I am a CLO trader. CLOs are NOT like the CDOs that brought down Bear Stearns. They are NOT backed by mortgages nor contain egregious amounts of other CLO tranches (ie, CLO^2). Banks generally hold only the most senior (AAA and AA rated) tranches of a CLO, which, in the complete history of the CLO market, HAVE NEVER SUFFERED A PRINCIPAL LOSS. Hedge funds and fast money shops hold the equity (or residual) tranches, i.e., the leftover interest that is available should the CLO manager pick the right loans to invest in and appreciate in value/do not default.
    The assets that back the CLO portfolios are NOT opaque nor complex; they are generally broadly-syndicated loans to companies, many of which you can easily recognize. Additionally, these loans and portfolios are readily accessible and contain all the information needed to analyze the holdings. The 12-month running default rate on the loan market is about 1%. ONE PERCENT. The default peaked in 2009, at 11%, and when you factor in that these loans do recover cents on the dollar (typically 70%+ for a bank loan), there is no way that the AAA/AA tranches were ever at risk.
    You can perhaps think of a CLO investment as a house: Even though the market ebbs and flows, it’s still performing its function as a place to live in. You don’t want to be forced to sell at a given point in time because you cannot say that it will be a good time.
    Are market players making bets on the loan market and CLO market? Yes. In the subordinate tranches, absolutely this is a credit trade. But the AAA/AA bank holders are investing for different purposes. In fact, many AAA tranches are considered almost a “cash alternative” because of their money-good reputation and decent liquidity (especially for CLOs that will mature).

    So, here is your CLO 1.0 course for the day. I tried to keep this simple for the sake of the author’s limited knowledge of the product.

  6. This is the BEST post this site has done in several months. And I want to 2nd commenter engineer27′s remark “Glad to see you are back to more regular blogging.”

    This site hit a great stride during and immediately following the 2008 economic crisis (the crisis dates before that, but that’s when “main street” felt it). The blog has fallen into a bit of a lull. While that is not a criticism in the sense that being a teacher and being a father to a gifted daughter easily takes precedent over blog posts, from a selfish standpoint and the standpoint of the dialogue, it’s nice to see Mr. Kwak back in the batter’s cage swinging.

    This is an OUSTANDING post. When time allows, let’s have more of these. It contributes to and IMPROVES the dialogue.

  7. I should say I miss the days when regular commenters here got put on the blogroll (hint hint hint). Some of these guys were “borderline Genius” {looks around to see if anyone can notice me barely containing my laughter]. Well that’s not like a hint to the blog hosts to do that. No…. Who brought up this topic anyway?? I mean really?? (hint hint hint) Putting regular commenters on the blogroll?? (hint hint hint). Rupert Murdoch would never put regular commenters on a WSJ blogroll. That would be amateur hour if you put regular commenters on the blogroll (hint hint hint).

  8. jbc, you were doing really well until the last sentence which simply makes you look arrogant.