While the article mentions the 2008 financial crisis, it does not mention that CLOs existed prior to the crisis and performed well during that time, much better than other securitized products.
> The CLO asset class has performed strongly, according to a recent report from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”), with few negative rating actions on senior notes due to underlying collateral deterioration, few defaults, and minimal loss rates since the agency started rating the asset class in the mid-1990s... Looking at the default statistics, of the over 6,100 ratings issued by S&P on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had their rating lowered to D as a result. Based on this, S&P calculated a 0.41% default rate, or just over four tranches for every 1,000 it has rated.
The reason is that the collateral is higher in the capital structure than debt so defaults are much less likely and recoveries in case of default are higher.
I don't like how pop-financial articles talk about risk and debt. Companies aren't "risky" like a crappy car is risky. It's not that they cut corners and put lives at risk. Leverage and debt are normally conscious decisions made by the company. There is some optimal debt level that they strive for. The higher the debt, the higher the cost, but the greater return you can make. So like anything it's a trade off. I also resent the fact that any company with a non-investment grade debt rating is written off as unworthy of credit.
[0] http://www.leveragedloan.com/sp-report-clos-show-strong-hist...
Trading CLO's has been expanding. One could argue far beyond a point where there is enough safe companies to lend to. That must mean the risk for CLO's is growing (Deja vu again)
Continues low interest rates make people look for better returns on their investments and people selling products to fill that need. They may forget to make sure their clients understand that there are no save investments in the market at current Fed rates. (Can we say deja vu)
CLO's now cover leveraged loans, meaning loans with no collateral other than future profit. Like people taking out mortgages on for-rent properties. (Deja vu, deja vu)
When they combine a number of risky assets into a single asset, they factor in an assumption that a number of these will fail. Others will not and given the payoff of those, the net investment pays off.
I don't know much about finance and how they do these calculations, so I'm going to say something dumb here, and maybe someone can tell me if they are being this dumb (or dishonest) when the calculate these things. Forgive the "explain it like I am 5" description.
There is a naive way of combining these probabilities which high school students probably know. However, this assumes the outcomes in question are not correlated. For example if you flip two coins, the probability of each coming up heads is .5 and they are not correlated, so the probability of getting two heads on two coin tosses is .25.
Of course, if the events are correlated, then that formula doesn't work any more. For example, if there is a new Quantum Coin Toss Manipulator (because we all know it would have to be quantum) that makes all coins flips near it come up the same, then the probability of getting 2 heads when you do two coin tosses is no longer .25 but instead it is .5. And, if you do 100 coin tosses, the probability is still .5 of getting all heads.
Back to the CDOs or CLOs. The chance of individual components failing is clearly not completely independent. Economic conditions such as a big recession presumably will have similar effects on the different components. So the naive formula does not apply.
Hopefully they are not being that naive or dishonest, but it seems like it would be pretty tricky to estimate the correlation and correspondingly difficult to estimate the true risk. Is it that case that they are just not good at estimating the correlation in the risks of these different assets?
For more detail: https://en.m.wikipedia.org/wiki/Modern_portfolio_theory
The CDOs in the 2008 crisis were designed for uncorrelated risks, but in a real estate bubble driven by too-lax lending standards, the risks were all too correlated.
Before the downturn this was stated by the New York Times, numerous finance blogs, and this golden quote:
"When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing."
Chuck Prince, July 10th, 2007 (then Citigroup CEO)
This trope is tired and very annoying each time I see it come up.
I'm an expert in Programming Computers (at least, that's my job, so I assume I'm an expert). So I laugh at WashPo or New York Times, or Bloomberg whenever they make simple computer-related errors in their article.
But guess what? I'm not paying Wash Po for my computer news. I'm paying ACM or IEEE actually for computer news. But ACM / IEEE have no news on financial markets. (Bloomberg is an expert newspaper in the realm of finance).
ACM / IEEE don't have many articles on politics. Washington Post is far better at describing the daily political issues in the capital.
Al Jazeera gets American news incredibly wrong sometimes. But I'll trust Al Jazeera on middle-eastern news over almost any American-based paper (aside from Wash. Po, which has a solid foreign politics / world politics section).
Throw in a few "Conservative" newspapers for the conservative slant on issues, and you can get a decent balance of news from a variety of sources.
I don't expect general Newspapers to be an expert in my field. I read newspapers to learn about things OUTSIDE of my realm of expertise. Believe it or not, newspapers have "specialties", and they're quite good if you read them based on what they're actually an expert in.
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Honestly, I don't read too much NY Times, so I dunno what they're an expert in. Financial news is definitely a Bloomberg thing IMO.
But individuals still only have expertise in a narrow field. I'm not going to be reading Herb Sutter's blog for Java-programming news, or "The Old New Thing" (Windows-blog) for even Linux-ARM news. I read Herb Sutter for C++, Old New Thing for Windows-specific stuff.
To get more information from a wider variety of sources, you end up reading Newspapers. You learn to trust the editor, a non-expert but someone who tries to promise quality of their writers follows a certain code. Even within a newspaper, different editors handle different sections (the OpEd section of WashPo is less factual than other sections)
As long as you understand the trust model of various sites or newspapers, things are good. Some amateurs on "Seeking Alpha" or "Medium" are pretty darn good with their analysis, you just gotta learn their names and follow them specifically.
There is an important difference. The people working in financial markets have lobby power to change laws and create more weaknesses.
So, it will be more like if black hat hackers paid part of the salary of the IT-Ops that have to patch the software. Half of the server will run on unpatched Windows 95 and there will be long discussions on why updating is not a good idea because of made-up-reasons.
The banks are going after stuff again because the protections were removed, not necessarily because they've found a new way around them.
From https://www.investopedia.com/terms/l/leverage.asp
I don't think that leverage is necessarily an issue, and it isn't black hat either. It's a normal part of any economy. The problem is scale. After the last two economic issues that we had to deal with, I have a sense that far too much of our economy runs on leveraging, in order to keep growth going. This isn't just happening with these C.L.O.'s, but with credit card debt, mortgage debt, medical & student loan debt, etc. on the personal level, and a whole slew of debt options for businesses. This is all necessary for the capital owning class to maintain their wealth, which is fed by a sea of debt: without economic activity to pay for goods, many things will lose value rapidly.
I've seen these leveraging games blow up twice in my life. I get to listen to people who claim to know economics tell me that it isn't going to happen this time, that it's different, but you are right. We didn't alter our economy in some fundamental way. We didn't create reward structures for building an economic system that would prevent this issue from happening so often, nor did we create a punitive structure for those who benefit and thus try to make it happen. Instead, we allowed those who benefit from these processes keep far too much of their ill-gotten wealth.
It's going to happen again, and my guess is that once again the middle class and poor will be punished for it. If a billionaire loses 90% of their wealth, it wasn't real anyways. When a middle class person loses 90% of their paycheck, or your more common millionaire loses 50% of their wealth, they can be completely devastated. I know, because I already saw it happen twice in my life.
The actual black-hat hack is and was regulatory capture. Sure, with good regulation perhaps the economy runs a bit slower, but all of our growth is based on an engine that burns through billions of barrels of oil a year (yet another debt/leverage to pay off) so perhaps that's for the best.
EDIT: Corrected tons of oil to barrels of oil.
That said, the GP wasn't about excessive leverage. It's about legalized scams, what is a very different problem, with much harder solutions.
I think though the institutional problem behind why this happens is compensation and bonus structures.
It is even more foundational in the sense that one guys that manages to land a deal is literally valued $100m to a company which seems like a good cost-to-company argument for a $10m bonus, netting in $90m. Simplistically, at least.
Is that who were suggesting?
Well .. yes? If you can figure out a product and sell it to people, why not? You could make an argument that the customers don't understand the risks of the product, but these aren't being sold to the unsophisticated public but to other people in the finance industry who ought to know better.
But even if it was all documented, we are not talking about millions of pages of paper. A typical documentation for one of these structures is 200-500 pages, of which a lot is mostly irrelevant. An investor taking a significant position in one of these structures ought to read the relevant parts. But even highly paid professionals can be lazy too.
If you ask me, they are the greedy party.
Part of the impetus for the 2007 crash was that investment companies like AIG were making complicated and obscure financial instruments that hid lots of risk, while also being the agency everybody looked to to grade the risk of financial instruments. They rated their own mortgage debt products as low-risk based on fraudulent analysis.
They look something like this...think of it as a set of rules for what the manager does with your money:
1) We invest you stocks/bonds rated <N> and above
2) We exit positions under <XYZ> circumstances
3) We enter positions under <ABC> circumstances
4) Past performance by following rules 1-3 is N%
No one failed to read these in the past, instead they focused on the potential profit, which blinded them to the potential downside. This is an investing 101 lesson, that continues to be taught to money managers each time their profit chasing occludes their risk management.
If you, a regular working class citizen, were burned by this(perhaps in your 401k), then it's worth reading the prospectus your fund manager sent you. When you see the list of funds included in your fund, you should have received a prospectus for each of those as well. Look for which funds make up the majority of your funds holdings, and read those prospectuses. If you find(and are uncomfortable with) one of those funds being a triple-leveraged ETF backed by 30-year mortgages, then you should talk to your fund manager about that.
Some token measures like deferred bonuses or long vesting stock options have been done, but ultimately this just pushed out the horizon a bit. So you have to take care no to be part of a cockup in 5 years instead of 1 year.
They are often not particularly skilled either, as those who can see through the game are on the other side of the trade. Working at a pension fund is not a sexy or exciting proposition by any measure, so talent tends to go elsewhere.
It's the same situation as bright researchers going to finance where they get paid multiples of what they'd earn in their own field.
Once you sign your soul to the devil, it is very difficult to get out. I'm speaking from experience.
Https://www.reuters.com/article/us-intervalfunds-loans/new-interval-funds-offer-alternative-investments-to-retail-investors-idUSKBN1IC290
https://www.bloomberg.com/opinion/articles/2018-07-10/clos-h...
https://ftalphaville.ft.com/2018/11/20/1542706123000/Who-s-b...