CLOs: Understanding COVID-19’s Impact on Credit

Published on
July 15th, 2020
Duration
41 minutes

CLOs: Understanding COVID-19’s Impact on Credit

The Big Picture ·
Featuring Ralph Delguidice and Chris Whalen

Published on: July 15th, 2020 • Duration: 41 minutes

In Part I of this The Big Picture, Chris Whalen, chairman of Whalen Global Advisors, sits down with Ralph Delguidice, global macro strategist at Pavilion Global Markets, to break down the intricate world of collateralized loan obligations (CLOs). Delguidice and Whalen break down how CLOs work and the impact of COVID-19 on the CLO market. Both Delguidice and Whalen provide their perspective on Frank Partnoy’s recent article called “Will the Banks Collapse?” in The Atlantic. Then tomorrow in Part II, Chris Whalen and Jason New, co-CEO and head of opportunistic credit at Onex, break down the difference between the CDOs – that helped fuel the great financial crisis in 2008 – and CLOs today. New also explains how COVID-19 related defaults could impact the opaque asset class. Filmed in July 2020.

Comments

Transcript

  • CL
    Cyril L.
    19 July 2020 @ 03:06
    The second part is much better. Amazing how much lazy analysis there is on this topic. CDO, CLO, they share two letters, they must then be the same! Not quite. There have been excessive issuance of CLOs, for sure. There will be some pain, for sure, in the lower rated tranches. Is it going to play out like the CDO market in 08-09, unlikely. The issues are not the same. For one, yes it's a short correlation trade, but correlation is structurally much lower in the corporate space (in terms of actual cash-flows). Yes Covid-19 impacts the whole economy but to a very varying degree. Telecoms are doing fine. Software businesses, food & beverage, pharmaceuticals, defence, etc. are doing fine. Many businesses are impacted but to an extent that doesn't threaten the viability of their capital structure. Basically, this market only blows up if there is a deep, lasting depression. And if there is, it will be the least of everyone's problems (size is not that big - depends on how you measure it, but say it's 1.5 trillion; the US commercial real estate market is c. 16 trillion, for example - , it won't be the most severely impacted and it's mostly held by institutional investors and hedge funds, not banks). Just because there might be losses in CLO equity and some lower rated tranches (which is not an anomaly, that's what equity and BB, BBB and even A credit is supposed to experience from time to time) doesn't mean that it will be the epicentre of the next financial crisis. That's nonsense. It might be collateral damage, but there are much bigger issues out there.
    • AG
      Aidan G.
      19 July 2020 @ 14:18
      You must work for a CLO sponsor. Good luck with job search.
    • CL
      Cyril L.
      20 July 2020 @ 02:11
      Solid counter-arguments. Thanks for your contribution. I will be fine, don't you worry.
    • AG
      Aidan G.
      20 July 2020 @ 19:21
      You want a counter argument? Listen to the guy's piece. I dont think he used the word CDO once. Looks like you agree on the fact there will be losses in the support bonds, right? You say correlation is "much lower in corporate space?" Tell Moodys. The downgrade/upgrade ratio just hit an all time high, and half the CLO universe in on CW negative. You say parts of the market are doing fine. So did he. "Good COVID stories," he calls them. His point (I think) is that those losses on the BBBs are going to be enough to make finding buyers for new BBBs hard, and that makes doing more securitization hard, right? The guy agrees that the BBBs are supposed to take losses--just not all at once, right? His point about problems in all the asset classes is well taken as well. Look at CMBX, and sub prime auto. Will the losses crash banks? He says not. Non-Banks? Different story. I honestly dont see what you dont get here, but he said the subject is delicate with some people given the revenues. Seem like a solid take.
    • CL
      Cyril L.
      20 July 2020 @ 23:36
      Well funnily enough the subject seems more delicate with you than with me. I have no problem acknowledging that there are issues. I just happen to know this market and while it's certainly not the least educated take I've read/heard on the subject (the article by Frank Partnoy in the Atlantic that they mention was terrible, for example), I don't think he has a deep understanding of it and in my view he's exaggerating some of the risks and misunderstanding some of the dynamics. And my comment didn't just apply to his answers but also to some of the questions and comments here and elsewhere on the topic. Could I be wrong? Of course. It happens often. What is a certainty is that you're wrong in assuming that disagreeing is necessarily equivalent to misunderstanding. I understand his view, and he's correct in some regards, I just happen to disagree with some of his conclusions and points. As is my right. There's no need to get angry about it. Breathe. Relax.
    • CL
      Cyril L.
      21 July 2020 @ 00:03
      Plus, friendly tip: no one should really give much credence to rating agencies. Some of their analysts are good, but it varies greatly, and their ratings are more influenced by their own business considerations (buying market share in up cycles, covering their behind in down cycles) than on credit analysis. Sad, but true. They've enabled the excesses in credit markets by being too lenient (again), and now they're downgrading as fast as they can often without careful analysis just to be on the safe side (again). The incentive structure is just wrong.
    • CL
      Cyril L.
      21 July 2020 @ 00:06
      Again, just my opinion. Don't take it at face value. I just want to encourage folks (that are willing to) to do their own research rather than relying on so-called experts' opinions.
    • AG
      Aidan G.
      21 July 2020 @ 18:36
      Not angry at all, just wondering if we read the same piece you regard as 'lazy analysis." It seems like you agree with the author on pretty much everything, except what the future holds here, calling that lazy is unfair IMO. As for Portnoy, don't be too dismissive. I agree the AAAs are unlikely to take much in the way of actual losses, but dont be too quick to assume they are all 100% intact. In CMBS we are seeing 100% PLUS loss rates (legal fees) on hotel and retail properties, and while you are correct t there are still 'good' parts of that market (Industrial) the scary stuff accounts for HALF the collaterals. Could AAAs be broken? Define broken. No AAAs take losses, OK; but many will get downgraded. Some sellers may be forced out. Several funds are failing the senior OC tests now, and that could hurt the LCFs. And FWIW saying no one gives credence to what the rating agencies say is just absurd. I dont know what you mean and I dont think you do either. Hence the room for 'misunderstanding' and not healthy debate. So I guess what you are saying is the BBBs will take losses, but it won't matter because there will always be more suckers to step up and buy them with other peoples' money. That is hard to argue with, I agree; but we will see.
    • CL
      Cyril L.
      22 July 2020 @ 03:13
      Well I should have been clearer, you're right. Calling this piece lazy analysis is unfair as there is at least some understanding and research, even though again I believe his understanding remains rather superficial. He's making some statements that are just factually incorrect or incomplete, and he is missing key dynamics. My comment was more prompted by other comments here and elsewhere, in which some folks are just concluding "oh it's exactly like the Big Short". It's not. On the rating agencies, I did't say no one gives them credence. I said no one should give them much credence. Their incentive structure is not healthy, for one, and corrupts their research to some extent, and also at the end of the day, they're not omniscient, their research is just opinion, and not always of great quality (again, varies by analyst, and I'm sure by sector; I only really read their corporate research. So their research is just one piece of the puzzle, and not the most critical. Re; the core of the argument, what I disagree with is the extent of the losses, i.e. I think CLO equity performance will likely be poor on average (but not certainly, who knows with the amount of fiscal and monetary support pouring in), some BBs might default but I don't think there will be catastrophic losses there (default doesn't mean it's a zero), maybe some BBBs because some managers have been very greedy, but I wouldn't expect defaults across the board. As and AAAs, unlikely to see defaults or very minimal. Now I agree with you that there will be some downgrades and volatility in the secondary market, but it's not a retail market, investors in this market have been through 08-09 and more recently 15-16, they expect volatility, that's why CLO tranches always price significantly wider than similarly rated vanilla securities. Why do I think that? It would be too long to list all the factors here, but I'll try to mention the most important. First, after 08-09, the rating agencies revised their model for CLOs and required more subordination so the structure carries less leverage now. So the structure is tighter, though that is offset by the lower average quality of the loans put in said structure, hence why I don't think CLOs will perform as well (but doesn't mean that they will blow up either; US CLOs performed spectacularly well through 08-09 and even European CLOs had only - literally - a handful of defaults despite negative IRRs on the equity on average). Second, there are very few companies having zero cash-flow right now (cinemas, hotels, etc. obviously but it's not a huge part of the market). Leverage and LTVs are lower in the corporate space vs. real estate because cash-flows are usually more volatile. A company can lose significant revenue before cash-flows turn negative, and if it's just for a temporary period most have the liquidity to survive. So most companies indirectly impacted by Covid might not default, but simply have a slow and painful deleveraging (which doesn't matter for CLOs). Even some companies directly impacted by Covid may have enough liquidity to survive through it. Of course no one knows how long it's going to last. Third, the thing with covenant-lite is that, all else equal, it likely reduces the default rate (because you remove one default trigger that typically comes ahead of liquidity issues, which for some borrowers might never materialize), but likely reduces the recovery as well. No one knows the net effect of that on credit losses, but it might not be negative. So there will be a default cycle, yes, but this is sub-investment grade credit, everyone knows that there will be a high % of defaults through the cycle, and CLOs are structured to withstand that. So a simple spike in loan defaults is not sufficient for CLOs to blow up; you need the worst default cycle in the past 30 years, by a significant margin. If we have another Great Depression, sure, CLOs won't fare well. Is that a given? I don't think so. So the disagreement is on the extent of the pain. I'm sure you'd agree that some defaults at the BB and maybe the BBB level with limited principal losses (my view) is quite different from his view (catastrophic losses across the board). Could I be wrong? Sure. No one knows how it's going to play out, everyone can have his/her own opinion, but right now it's not a given that we're going to have a Great Depression. It's a risk, sure, but not a given.
    • AG
      Aidan G.
      22 July 2020 @ 17:12
      His point is that losses in BBBs are going to make selling more of them at stupid low yields impossible for most issuers. That is how markets work. Securitization models CAN go extinct, look at the CDOs you keep trumpeting. Yes, they broke because they re-levered existing ABS, but you miss the reasons WHY they re-securitized. Simple: they did it to make the mezzanine go away. Selling BBBs is always the hard part, because they are ALWAYS ovepriced, and that is more true NOW as you point out given LESS leverage to the AAA--which trade at L+150 now verses L+75 then and ADDING to the cost of leverage to the mezz. I think if you re-read it you will see that 'catastrophic losses across the board' refers not to CLOs, but to all securitized asset classes in the mezzanine. Like rating agency credence, this is simply a fact. CMBS mezz is getting hit. Auto, aircraft ETCs. Its all looking ugly for the support bonds ALL AT THE SAME TIME. Like I said, we will see. Best of luck.
  • CL
    Cyril L.
    21 July 2020 @ 00:03
    Again, just my opinion.
    • AG
      Aidan G.
      22 July 2020 @ 16:41
      https://twitter.com/apark_/status/1285672770202894339
  • DN
    D N.
    16 July 2020 @ 13:54
    Interesting when raised that "covid is breaking the theory of securitization" which is intrinsically short correlation.
    • JF
      Jack F. | Real Vision
      17 July 2020 @ 20:12
      Yup, that's the heart of it right there
  • DP
    Duane P.
    17 July 2020 @ 03:04
    This was an excellent interview!
  • HH
    HODL H.
    16 July 2020 @ 05:06
    When he discusses private equity and CLOs, the the largest PE companies credit arms are also some of the largest CLO managers/issuers
  • HH
    HODL H.
    16 July 2020 @ 04:57
    Thank you!! Much needed discussion no one is talking about and much bigger concern/current issue than bitcoin, 100% best video since the COVID crisis
  • SS
    Shanthi S.
    16 July 2020 @ 03:15
    Wow!! Learnt a lot!! Thank you so much.
  • SV
    Stephen V.
    16 July 2020 @ 03:14
    "2 guys and a bloomberg" becomes 2 guys and a bitcoin node.
  • BK
    Brian K.
    16 July 2020 @ 00:02
    Free basic education on CLO and how they act in the current environment. WOW
  • DS
    David S.
    15 July 2020 @ 07:42
    Great discussion. Emphasis on liquidity vs. solvency a la Mr. Pal. A quick update during the crisis by both gentlemen would be very helpful. DLS
    • RM
      Rando M.
      15 July 2020 @ 15:15
      Hey. Please enlighten me about the meaning of DLS. I see it often in the comments and I doubt Im getting the right meaning from Urban Dictionary :)
    • DS
      David S.
      15 July 2020 @ 16:27
      There are several David S. commenting. My initials are DLS.
    • MW
      Max W. | Real Vision
      15 July 2020 @ 21:12
      DLS is the alpha and the omega. He was here long before any of us and he'll be here after we are gone. MRW
    • PG
      P G.
      15 July 2020 @ 21:13
      🤣
  • DR
    Danilo R.
    15 July 2020 @ 18:41
    A wonderful ticking time bomb courtesy of ... cough cough, financial crooks, with the illusion that debt is not correlated. These were created because US pension plans need a 7% return and believe they will be backstopped by Aunt Pelosi and Uncle Sam. Yes, the American taxpayer will be on the hook.
  • ar
    andrew r.
    15 July 2020 @ 18:39
    Two terrific contributors on an interesting topic. Very nice.
  • RM
    Richard M.
    15 July 2020 @ 17:11
    Excellent discussion of the CLO market. Really insightful analysis by Ralph and Chris. Looking forward to part 2.
  • JK
    Jake K.
    15 July 2020 @ 15:15
    Who are the main holders of CLOs by tranche rating (AAA, BBB, etc.)?
    • MW
      Max W. | Real Vision
      15 July 2020 @ 15:42
      Some of the best work on indexing CLOs is done by Palmer Square Capital. You can find info on their broad indexes here: https://palmersquarecap.com/clodi.htm. If you go into this page on constituents: https://palmersquarecap.com/uploads/2020%2006%20Palmer%20Square%20CLO%20Indices%20Statistics.pdf, you can find the BBERG tickers for the CLOs that they include in their indexes to track the health of the space. I picked a random ticker but wasn't able to find the "holder". Maybe someone can help me out here.
  • AD
    Andrew D.
    15 July 2020 @ 09:42
    As a corporate bond holder of Emirates NBD Bank (I have a significant holding), given it's a UAE bank, backed by the UAE government, rated A3 (according to Moody's), A+ according to Fitch.. would this be a high risk bond to hold over the coming years? The face value has depreciated by 3-4%, so wondering if I should exercise caution or whether it's nothing to be concerned of.
  • pp
    pakorn p.
    15 July 2020 @ 06:32
    thanks, I think we need a series of report on CLO as its impact could be much more severe than CDO especially this situation where central banks have no bullet left