CLO's quality low, the crisis close

In one of our previous reviews dedicated to CLO (collateralized loan obligation), we noted a sharp decline in the quality of this instrument.

When an investor buys a CLO, he estimates the probability of non-payment for this instrument, based on the rating assigned by the leading credit rating agencies. The higher the rating, the lower the likelihood of challenge and profit, but the lower the return and the other way around.

So today, the share of CLOs which rating is close to pre-default rate (about 40%). Note that on the eve of the global financial crisis, the proportion of mortgage loans did not exceed 13%. But this was enough for the entire pyramid of MBS, CDO and CDS to collapse, almost destroying the entire global financial system.

There is a question, how it is possible to achieve such an “impressive result” with a relatively low level of problematic mortgage loans? The answer is rating agencies (RA).

In pursuit of profitability (the assessment of each financial instrument brings tangible income to RA), S&P, Moody’s and Fitch gave ratings that did not correspond to reality, significantly underestimating the actual size of the problems. The crisis of 2007-2009 showed how rotten the RA system is and how far they are in their assessments from the truth - a significant part of the investment-grade MBS and CDO, in fact, turned out to be “junk” papers. The RAs subsequently admitted that they assigned higher ratings to thousands (!) of mortgage-backed securities.

And that was not only one case. Rating agencies before made mistakes systematically. Incidents with Enron, WorldCom, Lehman Brothers and many others show that even companies that are on the verge of bankruptcy might have high ratings. For example, in spring 2008 at the height of the financial crisis, Lehman Brothers shares fell by 50% (!) Fitch and Moody’s assigned the company a rating and category A. Recall, that year in the autumn the company went bankrupt.

The underlying reason for that is money. Each rating is an income for a rating agency. But besides this, the rating is a rather powerful tool of influence, and from time to time the RAs use this (lower ratings scare off investors). For example, once, the German company Hannover Re refused to cooperate with Moody’s. In response, RA lowered the ratings of the company and it lost 175 million dollars in a few hours.

That is, 40% of problematic CLOs in the market represent only a part of distressed loans. In reality, the situation is much worse. The magnitude of the problem is hundreds of billions of dollars. Given that the global crisis base has already been prepared by the trade war, it is all about the “pull ring” and what will detonate the grenade. The CLO market may well pull that ring and as MBS, CDO and CDS in 2007 could lead to the development of the crisis.

The crisis, in turn, will provoke massive sales in the US stock market. Considering that the NASDAQ100 index has grown 8 times over the past 10 years, the shares of the US technology sector seem to be the best candidates for sales.