In the wake of the most severe recession since the 2008 financial crisis, even historically low interest rates and Biden’s unprecedented government expenditures might not be enough to protect the US economy from total collapse—at least not in the long term. With the unemployment rate finally recovering from historic highs and GDP growth back on track, most might think they see light at the end of the tunnel. However, as some of the largest banks face increasing debt-to-asset ratios with uncomfortably low levels of liquidity, and as household consumption rates struggle to return to pre-pandemic levels, American businesses might not build back better as fast as Biden hopes.
The Build-Up to 2008
Before the financial crisis of 2008, economists, bankers and even regulators at the highest levels of government scrutinized about the unprecedented mortgage default rates, rising delinquencies and falling home prices dismissed the reality of the financial bubble. In harmonious chorus, those considered to be experts of finance lectured the world “how what makes a bubble a bubble is its impossibility to recognize”. But for those paying closer attention to the corruption and risk permeating the market in 2008, the likelihood of collapse was only a matter of time. So what did the few analysts and small hedge fund managers who saw the crisis coming notice when the rest of the market was blissfully turning a blind eye?
Most notably, the clairvoyants who predicted the 2008 financial crisis recognized four pivotal shortcoming in the market. First, the nation’s largest investment banks, Lehman Brothers in particular, were extremely leveraged with low levels of liquidity. In the case of Lehman Brothers, for every $1 in assets they held, the bank had $36 dollars in debt. In other words, if banks had to dramatically increase their outlays and debt payments they wouldn’t have enough cash to afford their payments and avoid bankruptcy. Second, the entire financial system and the largest generator of credit in the economy was built on the back of bonds called collateralized debt obligations, or CDOs. These bonds were comprised of layers of thousands of individual mortgages that banks would package and sell off to institutional investors. If these bonds lost their value, the world economy would be brought to its knees.
In addition, the few omniscient pessimists saw that millions of the mortgages that made up these CDOs were incredibly risky, ie. it would be very unlikely given the credit score and income levels of borrowers that these loans would be paid back. Finally, and perhaps most consequentially, the private agencies that rated the risk of CDOs received fees from banks for ratings instead of analyzing the risk of these bonds objectively. As a result, the vast majority of the market was led to believe that these bonds were as stable as US Treasury bonds despite that their underlying value would entirely deteriorate as homeowners became increasingly unable to pay their mortgages. In the aftermath of the crisis, the benefit of hindsight made many of these red flags crystal clear, so experts, economists, and regulators were left to ask: how can the government and the market come together in order to prevent this level of risk and delusion from ever again reaching such disastrous levels?
Casting a Safer Future
After the total deterioration of mortgage backed securities in 2008, banks and investors were eager to find a new lifeblood for the economy. Before the dust could settle, banks quickly embraced a new type of bond that they were confident would not come with the same unforeseen risks CDOs possessed. These newer, and supposedly less risky securities, were called collateralized loan obligations, or CLOs. As their name indicates, these bonds are nearly identical in structure to collateralized mortgage obligations, but instead of layering home loans, these bonds layer loans that banks and investment firms had given to companies. Like CDOs, large investment banks compile thousands of corporate loans into a bond, and then sell the bond off to an institutional investor who receives the bond and the interest payments that companies owe on their loans. Both the government and the private sector were quick to jump on CLOs because their “securitization”, or the sale of these bonds to investors, generated more funds that banks could then loan out to stimulate economic activity in the heart of the recession.
As CLOs became the preeminent industry standard, Congress was busy passing more stringent regulation on banks that legally prevented these institutions from adopting the same levels of risk they had before 2008. Chief among these reforms was a new debt-to-asset ratio baseline enforced by the treasury department that mandated banks hold at least 5% of the value of their total debt in liquid capital, so that in the event of a crisis, banks would have some backstop to avoid bankruptcy and collapse.
However, despite these new mandates designed to prevent the permeation of risk throughout the market, most banks, particularly in the recession caused by the pandemic, have been leveraged well past the legal minimum. These banks haven’t been shut down or compelled to pay large fines: in most cases, the only consequence has been that they have to submit proposals to federal regulators explaining how they will rebalance their debt-to-asset ratios. In other words, the faith that the market and the American public place on the government’s ability to correct systemic flaws within the financial industry is like the faith you’d place in a lifetime thief’s promise not to steal after you gave them a good scolding.
The Stability of CLOs
Accepting that government regulation is likely too spineless to save the market from the next crash, the market’s endurance throughout the lasting implications of the Covid-19 recession will depend on the stability of CLOs. With the hindsight the market should have gained from the 2008 meltdown, policy makers and analysts should be focusing their attention towards two critical components of the CLO market: the underlying risk of the lower-rated loans within these bonds (loans made to companies more likely to default) and the viability of collateral investors would receive if these bonds do fail.
Federal regulation requires that CLO portfolios contain a maximum of 7.5 percent “CCC” rated loans (loans given the lowest rating by private agencies because of their higher likelihood of default). However, throughout the pandemic crisis, as many medium and large-sized companies have struggled to persevere, “CCC” loans have comprised more than 9 percent of CLO trades throughout the recession, rising above the federal limit. Further, nearly 70 percent of CLO portfolios are comprised of “B” or “B-” rated loans, loans also considered to carry a significant degree of risk. In other words, with a sharp rise in the underlying risk that the majority of CLO portfolios have begun to carry, and with a banking sector already highly leveraged and therefore unable to extend the amount of credit necessary to keep these higher risk companies afloat, nearly $700 billion dollars of capital—one of the market’s primary sources of investment—is nearing the brink of complete deterioration.
Further, both the Federal Reserve and the Treasury Department enforce collateralization standards on the formation of bonds like CLOs that require the businesses who receive loans to post collateral in the event that they cannot pay back their loans, so the bonds don’t collapse in the value. The problem is, as the Harvard Business Review reports, small and mid-sized businesses that comprise the more riskier layers of CLOs face both diminishing available collateral due to the pandemic and a banking sector already strapped for liquidity. In this sense, not only are pandemic conditions deteriorating the underlying value of CLOs, but are also washing away the one safety net investors have if the underlying loans within CLOs deteriorate.
The Crisis on Our Doorstep
Whilst the conditions of the CLO market suggest there might be a crash around the corner, as in the case of every meltdown, the conditions surrounding and contextualizing unstable markets determines how impactful the meltdown will be on the larger economy. In 2008, even financial experts who began to recognize that subprime mortgage markets were on the brink of collapse firmly believed that the failure of these markets would be contained: they did not believe the failure of riskier home loans would impact the larger mortgage market, and they certainly believed that the longest standing investment banks in American history couldn’t be brought down as easily as a stack of dominoes. But either this apathy or delusion in 2008 should beg a fundamental question about the status quo of current credit markets. Once the Trump and Biden Administration’s emergency loans to businesses run out, will the banking sector have the liquidity to extend the same level of loans in place of the government?
Aside from the fact that banks are already facing increasing debt-to-asset ratios, the pandemic and the dramatic increase in demand for credit as businesses have struggled across the country has severely dried up the market for liquidity. This is one of the primary reasons why the CARES act and Biden’s Covid relief package included over $2 trillion in loans to struggling businesses. However, as household consumption rates fail to return to pre-pandemic levels, and as the unemployment rate struggles to return to its natural level, there is no certainty that the market place will both generate enough demand and income to boost spending to the necessary levels. As estimated by the government’s current level of loans extended to under-capitalized businesses, the banking sector would need to generate more than $2 trillion in credit to prevent thousands of businesses, many of which are integrated into the lower tranches of CLOs, from going belly-up.
Not only are current liquidity markets strapped far below the necessary amount of credit businesses would require once federal assistance runs out, but there isn’t even a guarantee that large banks would be willing to loan out the money that is available. With interest rates still hovering at unprecedented lows, as the Federal Reserve attempts to spur economic activity, during the current recession large commercial banks have actually substantially increased their holdings of excess reserves. This means, despite the Fed’s effort to expand access to credit markets for struggling businesses, large banks would rather hold the funds they receive from the Federal Reserve in their depository accounts then loan it out for a relatively low return given the miniscule level of interest rates.
While the unparalleled levels of excess reserves could mean that the market will have a backstop in the event that countless firms again have balance sheets with far more debt than they can afford, this phenomenon does not dismiss the kiss of death that all financial bubbles bear on the market. Even with Treasury Secretary Paulson’s ability to organize last-minute buyouts and loans in 2008 and Fed chair Bernanke’s federalization of mortgage holdings, the outstanding debt of financial institutions may have been just barely paid off, but the value of these assets and of the companies that previously held them would take years to recover.
In this sense, the next financial crisis is not just damning, but enduring. Even if the market place, Congress, and the Federal Reserve can put together the cash to afford the exploding debt that will manifest if CLOs deteriorate, both the value of these bonds and of the institutions that are heavily invested will collapse. If, by the grace of American ingenuity and a miraculous renewal of consumer confidence, struggling businesses can make a productive return and manage the debt they accumulated during the current recession, perhaps the tunnel does end in light. However, in this moment, all of the chips are on the table: in one of the most consequential economic moments of the new millennium, the resiliency of American business must meet the expectations of its financiers. This time, what happens on Main St. matters to Wall St.
Featured Image Source: The Atlantic
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