July 30, 2018
I’m beginning to feel like the mouthpiece for the complacency lobby, but we continue to see baseless articles in prominent places telling us that another financial crisis is imminent. The latest entry comes from Steven Pearlstein at the Washington Post, warning us that “The junk debt that tanked the economy? It’s back in a big way.”
The villain in this story is collateralized loan obligations (CLO). These are securities that put together a variety of loans and then are sold off in tranches. The tranches are ranked with the more senior ones getting the first claim to payments and least senior ones getting the last claim. This way a pool of risky loans can be used to create senior tranches with top investment grade ratings. The least senior tranches will be very risky and carry junk ratings but will offer a high rate of interest.
Pearlstein warns that the growth in CLOs has been explosive.
“Because the market seems to have an insatiable appetite for CLOs, leveraged lending and CLO issuance through the first half of the year are already up 38 percent over last year’s near-record levels.”
Sounds really scary, but how much is 38 percent above last year’s levels? Pearlstein never gives us a number, but a little digging tells us that the CLO market is just over $1 trillion. So how worried should we be?
Let’s call in Mr. Arithmetic. Suppose that 40 percent of these CLOs go bad, an extremely high percentage. That would be $400 billion in CLOs that could not be paid off in full. Of course, most people would still be getting their payments, since most of the loans in a CLO would likely still be paid. Let’s assume a loss rate of 40 percent on this $400 billion, a very high loss rate. That translates into $160 billion in losses.
Is this another financial crisis? We have a GDP of $20 trillion, making these losses equal to 0.8 percent of GDP. Arguably, our total wealth of close to $100 trillion is the better denominator, putting the losses at 0.16 percent of total wealth. Are you scared yet?
The story of the financial crisis was one of loans that were directly linked to a seriously over-valued asset that was widely held (housing). When the housing market collapsed, the loan supporting the market also collapsed, creating a downward spiral where falling house prices led to greater default rates, which also undermined the market for home purchases, further depressing prices.
The collapse in housing led to both a huge plunge in construction of 5 percent of GDP ($1 trillion annually in today’s economy) and a plunge in housing wealth driven consumption of almost 3.0 percent of GDP ($600 billion in today’s economy). That is what tanked the economy as it is not easy to find a way to replace lost demand equal to 8.0 percentage points of GDP.
This is hugely different than Pearlstein’s absurd story about CLOs crashing the economy in 2008. Of course, it doesn’t mean that we should not be worried about this risky loans. It is likely that lenders are making big bucks selling tranches to people who do not understand the risk. This is not a way to promote economic growth. This rip-off finance is a pure waste to the economy and diverts resources from productive uses. But it will not crash the economy.
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