Collateralized loan obligations: could these obscure products cause the next global financial crisis
At the heart of the global financial crisis of 2007-2009 was
an obscure credit derivative called the collateralized debt
obligation (CDO). CDOs were financial products based on
debts—most notoriously, residential mortgages—which
were sold by banks to other banks and institutional
The profitability of these CDOs largely depended upon
homeowners’ ability to repay their mortgages. When
people began to default, the CDO market collapsed. And
because CDOs were interwoven with other financial and
insurance markets, the collapse bankrupted many banks
and left others requiring government and central bank
Many thought this would put an end to the market for
complex structured credit derivatives, but it didn’t. As of
2021, a close cousin of the CDO known as the
collateralized loan obligation or CLO was approaching the
equivalent value of the CDO market at its peak. A record
number of CLOs were issued in August, and the market
as a whole is approaching $1 trillion in
value. Many within the financial services industry say that
there is nothing to worry about, but there are good
reasons why they could be wrong.
How CLOs differ from CDOs
Collateralized loan obligations are underpinned not by
mortgages but by so-called leveraged loans. These are
corporate loans from syndicates of banks that are taken
out, for example, by private-equity firms to pay for
Proponents of CLOs argue that leveraged loans have a
lower record of defaults than subprime mortgages, and
that CLOs have less complex structures than CDOs. They
also argue that CLOs are better regulated, and carry
weightier buffers against default through a more
conservative product design.
None of this is untrue, but this does not mean risk has
disappeared. Mortgages, for example, had low rate of defaults in the 1990s and early 2000s. But since CDOs
enabled banks to sell on their mortgages to free up their
balance sheets for more lending, they began lending to
riskier customers in their search for more business.
This relaxation of lending standards into subprime
mortgages - mortgages issued to borrowers with a poor
credit rating - increased the eventual default rate of CDOs
as people who could ill afford their mortgages stopped
repaying them. The danger is that the same appetite for
CLOs may similarly reduce standards in leveraged
In one respect, CLOs may even be worse than CDOs.
When homeowners failed to repay their mortgages and
banks repossessed and sold their houses, they could
recover substantial amounts that could be passed through
to CDO investors. However, companies are rather
different to houses—their assets are not just bricks and
mortar, but also intangible things like brands and
reputation, which may be worthless in a default situation.
This may reduce the amount that can be recovered and
passed on to CLO investors.
In a recent paper, we examined the similarities between
CDOs and CLOs, but rather than comparing their design,
we examined legal documents which reveal the networks
of professionals involved in this industry. Actors working
together over a number of years build trust and shared
understandings, which can reduce costs. But the
mundane sociology of repeat exchanges can have a dark
side if companies grant concessions to each other or
become too interdependent. This can drive standards
down, pointing to a different kind of risk inherent in these
The US-appointed Financial Crisis Inquiry Commission
(FCIC) found evidence of this dark side in its 2011 report
into the CDO market collapse, underlining the corrosive
effects of repeat relationships between credit-rating
agencies, banks, mortgage suppliers, insurers and others.
The FCIC concluded that complacency set in as the
industry readily accepted mortgages and other assets of
increasingly inferior quality to put into CDOs.
Unsurprisingly, creating CLOs requires many of the same
skill sets as CDOs. Our paper found that the key actors in
the CDO networks in the early 2000s were often the same
ones who went on to develop CLOs after 2007-09. This
raises the possibility that the same industry complacency
might have set in again.
Sure enough, the quality of leveraged loans has
deteriorated. The proportion of US-dollar-denominated
loans known as covenant-light or cov-lite – meaning there
are fewer creditor protections – rose from 17% in 2010 to
84% in 2020. And in Europe, the percentage of cov-lite
loans is believed to be higher.
The proportion of US dollar loans given to firms that are
over six times levered – meaning they have been able to
borrow more than six times their earnings before interest,
tax, depreciation and amortization (EBITDA) – also rose
from 14% in 2011 to 30% in 2018.
Before the pandemic, there were alarming signs of
borrowers exploiting looser lending standards in
leveraged loans to move assets into subsidiaries where
the restrictions imposed by loan covenants would not
apply. In the event of a default, this limits creditors’ ability
to seize those assets. In some cases, those unrestricted
subsidiaries were able to borrow more money, meaning
the overall company owed more in total. This has strong
echoes of the financial creativity that drove riskier
borrowing in 2005-07.
So how worried should we be? The CLO market is
certainly very large, and corporate defaults could soar if it
turns out that the extra money pumped into the economy
by central banks and governments in response to the
COVID crisis provides only a temporary reprieve. The
major buyers of these derivatives again seem to be large,
systemically important banks. On the other hand,
according to some accounts, these derivatives are less
interwoven with other financial and insurance markets,
which may reduce their systemic risks.
Nevertheless the market is at least large enough to cause
some disruption, which could cause major ripples in
the global financial system. If the networks behind these
products are becoming blind to the risks and allowing
CLO quality to slowly erode, don’t rule out trouble ahead.
Daniel Tischer, Lecturer in Management, University of Bristol
Adam Leaver, Executive Associate Dean for Academic Programs, Glenn Professor of Accounting & Society, University of Sheffield
Jonathan Beaverstock, Professor of International Management, University of Bristol
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