Is there going to be a bank collapse?

In the unlikely case that you have convinced yourself that the Great Recession is a thing of the far past and that we have successfully taken measures to ensure that something like what happened in 2007-2008 cannot happen again, I urge you to read The Atlantic’s excellent, albeit scary article The Looming Bank Collapse by Frank Partnoy.

As we learn from Partnoy’s solemn analysis, the reforms that were introduced after the 2008 financial crisis have failed their purpose of regulating the (U.S.) financial industry and thus ensuring financial stability and transparency. Indeed, post-crisis bank behavior has turned out to be so similar to pre-crisis behavior it seems almost cynical. Demand for collateralized debt obligations (CDOs) and the absurdly complex synthetic CDOs (the villainous investment products instrumental in the crash of 2008) has been replaced by demand for something called collateralized loan obligations (CLOs). If you think these things are similar, you are right. Whereas a CDO represents a construct used by banks to repackage and sell loans such as individual mortgage loans (subprime variants of the latter being the catalyst for the 2008 fiasco), a CLO is basically the same thing, only backed by corporate credit in the form of leveraged loans. And more often than not, the corporate credit involved seems to be tied to troubled businesses. So what we have here are basically the “subprime mortgage loans of the corporate world”, as Partnoy explains. And what’s really scary: The current CLO market is apparently bigger than the subprime-mortgage CDO market was in 2007. Interestingly, the CLO constructs have been receiving praise from the U.S. Federal Reserve and the Treasury. Risk is being downplayed.

You see where this is going, right? True, there are some factors that make the current environment seem less dangerous than the period just before the credit crisis of 2007-2008. The impact of potential CLO loan defaults is not directly comparable in strength to the impact of mortgage defaults before the financial crisis. But once again, the devil is in the detail, in this case the credit ratings given by agencies. The rating structure for the layers within the CLOs is highly misleading -just as it was for the CDO-tranches before 2007. So by having CLO investments, the big investment banks are exposed to a huge amount of high-risk debt. And once again everyone is thinking “no way so many (corporate) loans could default at the same time”.

So in effect, what we have here is a situation that is almost comically similar to what we had before the financial crisis thirteen years ago. And as Partnoy tells us, leveraged-loan defaults are already happening. Is it time to wake up?

Featured post image: Photo by Ehud Neuhaus on Unsplash

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