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Comment by dia80 | Hacker News Reader

Meh, the article doesn't mention recovery rates. If a loan defaults it's not usual you are getting 0 back. Typically 30-40% is the assumed rate. That means if all the loans default then the top 30% of tranches shouldn't take a loss.

So now consider, most of the underlying loans have to default and the recovery rate has to be below battle tested assumptions before the top tiers get risky. This is very very unlikely to happen given the Fed and the US Govt. have done so much and are committed to do more to stave off a severe depression / recession. It's more like people were killing it buying the safer parts at distressed prices as over leveraged funds shed them on the back of margin calls in March.

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Cov-lite loans are at the largest percentage of issuance of all-time. 30-40% with a complete lack of meaningful covenants in a lot of cases is wishful thinking.

Additionally, what's new about this cycle is tech companies being a massive percentage of issuance. What's the recovery value of a tech company with little to no real assets? Additionally, what's the recovery value of an energy company when oil has dropped as much as it has? Both of those sectors make up a huge portion of outstanding and will move the needle meaningfully even if other sectors are fine.

I probably agree with your overall point about the Fed and and govt but you really cannot use historical assumptions for recovery rates this cycle.

It says this:

> We already know that a significant majority of the loans in CLOs have weak covenants that offer investors only minimal legal protection; in industry parlance, they are “cov lite.” The holders of leveraged loans will thus be fortunate to get pennies on the dollar as companies default—nothing close to the 70 cents that has been standard in the past.

Also, a lot of people make 10x levered bets on AAA instruments, which means even a 10% loss can wipe you out.

The trick is "repo", or repurchase agreements.

(1) Buy bonds

(2) Use those bonds as collateral for a low-interest loan

(3) Use the loan money to buy bonds

(4) goto 2

See, e.g [1]

[1] https://www.bloomberg.com/news/articles/2020-04-15/how-repo-...

Aha. Is this how folks actually attain worthwhile rates of return on very low-return, low-risk investments?

[EDIT] well no that can't be it because it requires even more money coming in for those loans, which can't provide more expected return than the bonds they're buying or the whole thing would be pointless.

The "haircut" on risky assets stops you leveraging it too much. I think it's about 5% for US treasury bonds. So for every 100 I want to finance I need to have 5 cash on hand. Itsuch higher for riskier assets and that keeps leverage down. Also when things start to get edgy banks demand a bigger haircut further reducing the available leverage forcing you to delever (e.g. March)

If you step through the arithmetic, you see that a 5% haircut can take you to 20x leverage. It's a geometric series.

That means that investors' internal risk limits are the binding constraint, not repo haircuts.

It's another way of saying that the financial sector sets its own leverage. Historically, that has not turned out well. It's why Dodd-Frank included a leverage rule for large banks.

> That means that investors' internal risk limits are the binding constraint, not repo haircuts.

While part of risk, expected return is a larger binding constraint in most cases over risk limits. I'm probably not going to lever up 20x for an tiny expected return. On the other hand, I may very well lever up 5-10x on something 50x more risky than treasuries if the 10yr is yielding 0.725%.

In practice most PM's have a VaR limit and a battery of dollar exposure limits, which are all set by the risk department.

There is some credible research which suggests that large financial institutions act as if they are optimizing mean return subject to a VaR constraint [1].

[1] https://www.nber.org/papers/w18943

VaR is a fake number for way too many reasons to get into and anyone who paid attention to VaR these past few months would have lost a ridiculous amount of money. I only have experience working for hedge funds and how risk is managed greatly differs from fund/strategy/assets traded. Banks no doubt manage to VaR but banks also supposedly don't have prop trading desks anymore so they function much differently now.

The discussion seems to have shifted to argument for argument's sake.

But for the sake of argument: large bank VaR models affect hedge funds because hedge funds get their leverage through their prime brokers which are... large investment banks.

My bad, I missed that. Still I don't think your are going to see a meaningful fraction of highly rated CLO tranches default.

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