Collateralized Loan Obligations (CLOs) and the ‘Intelligent Investor’?

Kavi Chauhan

Due to the success of the ‘tranching’ structure used in work surrounding home mortgages in the 1980s, Collateralised Loan Obligations were created- they began, simply, as pools of mortgages,  tranched to appeal to different types of investor. A CLO is a form of derivative in which payments from ‘middle to large sized firms’ loans are pooled together, and then redistributed to different owners in ‘tranches’. These tranches (coming from the French, ‘tranche’-slice) are similar to bonds in that they are small pieces of an establishment’s debt that can be higher risk with higher ‘coupons’ or ‘senior claim’ levels, or be lower risk with lower senior claim levels- this process is called senioritisation. The risk, in the case of CLOs (and other types of Collateralised Debt Obligation-CDO) is in the establishment defaulting on their loan. With a CLO, however, in the case of a firm that was already at high risk of defaulting, a default would lead to a much larger affect on those who own higher coupon CLOs. Due to the success of the ‘tranching’ structure used in work surrounding home mortgages in the 1980s, CLOs were created- they began, simply, as pools of mortgages and tranched to appeal to different types of investor.

There are a number of problems with CLOs, and derivatives in general, which shall not be discussed until the question of ‘Why?’ is asked. Why should people invest in CLOs? CLOs can offer an alternative for those who do not wish to buy bonds, or preferred stocks especially for those to whom debt and equity is of interest. CLOs, can also offer a way for investors to balance their portfolio of derivatives at a lower cost, much like a security-backed Mutual Fund would do for an investor in the stock market. They also allow those who want to have their portfolio in the middle-ground between high-risk and low-risk as there are still tranches that will be rated at BBB rating- in the same sense, this type of security can offer more or less security in its different tranches. Another benefit to these is when fungible assets are included in the leverage positions and their amortization, but the fungible assets actually turn out to be over-valued: this can mean that the higher coupon for the higher risk that comes with greater leveraging was actually an overestimation. Due to this over-estimation, investors can gain larger returns for a lower risk: Warren Buffet is an example of an investor, renowned for his eye for solid investment opportunities, who purchased a CLO, through Berkshire Hathaway. These types of transactions also helped develop the market for CDSs (Credit Default Swaps), and CLNs (Credit Linked Notes). CDSs are a form of insurance that can be taken out against bonds taken from the coupon value that insure that the premium is fully paid upon maturity, even if the bond is defaulted against- these feature in what are known as ‘Conventional CLOs’. Synthetic CLOs are those which are transferred to a third party in return for a CLN- a CLN is another type of security by which investors take on a higher risk for the direct obligation of the issuer as it essentially has a CDS integrated into it.

In the case of those that were distributed before the crash of 2008, they were not perceived as at all risky and an opportunity with relatively low risk and high gains is one that very few speculators will pass up. The majority of these CLOs were highly rated because of a compound error that had occurred due to a slackening of the regulations and standards amoung crediting agencies such as Moody’s and Standard and Poor’s for large companies simply taking out loans, their risk was underestimated, causing the overall risk that each CLO would take on. On top of this, the rating of each of the individual tranches’ risk – due to that same fall in standards- was underestimated- thus, even extremely high-leverage positions would be seen as relatively low risk of defaulting. Further to this, Felix Salmon pointed out, in 2007, in an article for The Economist that many CDOs and CLOs actually had stakes in other derivatives of varying risk, thus adding a third layer to compounded problem. This meant that, when a loan that would have been a larger proportion of the lower-risk tranches fails spectacularly, the more ‘conservative’ investors would be at a loss. The main problem with this is that conservative investors like the ‘Grahmites’ pension fund managers, and if these people lose money, they will probably lose vast sums due to their huge portfolio sizes. Also, because these CLOs can be extremely wide reaching: Alan Greenspan (Chairman of the Fed until 2006) said that, these complex derivatives were the things that connected the solvency and risk of people across the globe, rather than concentrating it in central banks. He believed that if Bear Stearns did not have a “derivatives book, my guess is the Fed wouldn’t have had to do what it did”.

It was the realisation of the risks associated with CDOs and other derivatives that lead to the massive drops in sales of them after the subprime mortgage crisis. Now, however, things are beginning to change- the graph below shows that CLO volumes for the US alone have been increasing rapidly, with further increases expected in the coming years (see Fig. 1 and Fig. 2). Now, due to the new laws surrounding banks’ levels of equity enforced by the FCA and PRA (in the UK), and much stricter rating agencies there should be less undervaluing of risks incurred by CLOs. Does this make the sudden surge in CLO sales from the likes of Citi, Bank of America, and Barclays, with a total of $9bn in sales of CLOs, less worrying than the rise that happened before the subprime-mortgage market crash? At first sight, the answer would be no, but this would be ignoring typical human nature and history. After the Great Depression of 1929, one of the most severe deleveragings in history, the SEC, the FDIC and the Glass-Steagall Act were all set up in order to prevent another crash: both the SEC and the FDIC failed to prevent the speculative markets from returning and causing another deleveraging; and the Glass-Steagall Act was actually revoked in 1999. So, with the benefit of hindsight, will this sudden change of heart of financial institutions be permanent, or is simply another phase in the long-term debt cycle? Well, while some may, speculate that this is a change for good off of the back of one of the worst global financial crises in history, History has a tendency to repeat itself and humans, in mass, tend to repeat themselves. One of the main problems identified by Warren Buffet, Ray Dalio, Felix Salmon, and so many others with derivatives as an entire investment branch is that they are becoming increasingly complex ever day- with people like Fabrice Tourre prowling the markets with these tools at their disposable many unsuspecting investors will be ensnared. Also, as derivatives become more and more complex due to efforts to gain higher and higher profit margins on short term bids, even if the financial authorities sustain their current high standards, the market will repeat itself –in both the long and short-term debt-cycles.

So what should the ‘intelligent investor’ do? Firstly, to define the intelligent investor- Benjamin Graham and David Dodd in their books Security Analysis, and The Intelligent Investor committed to  writing the most sound investing techniques to date with regard to ‘margins of safety’ and long-term investing strategies. Buffet called The Intelligent Investor, “by far the best book on investing ever written”- it revolutionised the way in which people approach value-investing. The intelligent investor researches the underlying value before investing in anything and is not swayed by short-term market fluctuations; always having an appropriate ‘margin of safety’ on each investment, avoiding high-risk high-reward opportunities. The ‘conservative investor’ will adhere to a stratagem of purchasing stocks and bonds with steadily growing value –not price- that will create a portfolio that does not need to be altered more than twice every year. The ‘enterprising investor’ has the same high standards when they pick their investment opportunities, the only difference being in the amount of time and effort that they are able to commit to their choices.

Apart from the occasional CLO which may be undervalued and of a low risk, these types of investment are simply not appropriate for even the most ‘enterprising’ investors: better would be premium bonds, and ‘bargain price’ high underlying value stocks. Of course, these are extremely simplified parameters around which one should invest, but they offer a rough guide to those whom are interested. Sound advice for any individual planning to begin investing should take the time to read and fully understand the strategies of the most successful investors of history and the present day. Two of the fatal flaws of many of those who lose money in the markets of today are that they over-commit, and that they fall victim to the overly complex deals of financial predators. Jason Zweig writes on the former of these two traps in his additions that he made to the most recent edition of ‘The Intelligent Investor’:

He notes that “Nearly all the richest people in America trace their wealth to a concentrated investment…” but he then points out “To make it onto the 2002 Forbes 400, the average 1982 member needed to earn only a 4.5% average annual return… Only 64 of the original members – a measly 16%- were still on the list in 2002.”

With regards to the latter of the aforementioned pitfalls, Warren Buffet, Alan Greenspan, and a senior analyst at DuPont with whom I have spoken have outlined that many a feckless investor have and will continue to fall prey to derivatives and schemes that are designed to be so complex that misplaced trust will lead to large returns for the issuer and large losses for the purchaser.

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