Ownership Disclosure: Danielle Town owns shares in Berkshire Hathaway (BRK).
Table of Contents
1. Practice Crash
2. Will the Banks Collapse?
4. Risky Holdings
5. Let’s Get Practical
1. Practice Crash
Heading into our summer break at the end of this month, I have the feeling that I want to be a little more prepared for unpleasant surprises in the market showing up. It seems that, every week, some new negative economic outlook gets headlines, and the stock market completely ignores it. The market seems to think we’re going to go back to “normal” in about six months, and is acting accordingly. They’re waiting it out. They’re waiting it out while real people have lost their jobs, can’t pay rent, can’t pay their house payments, and are facing the dilemma of how to provide childcare if schools are not full-time and reliable after the summer holiday. I frankly have no clue when or if the market will ever recognize such negativity happening in real life, but I do think that if it does, it’s going to happen fast. Once the balloon of optimism gets popped, it will fizzle away loudly and dramatically.
Therefore, I’ve been gathering information about past recessions and crashes to inform my thinking. What follows is a collection of information that I suggest you use as your own starting point in your own practice. I don’t know what is going to happen in this market or whether it will go up or down or sideways, and all of my opinions expressed here are my opinions alone, and not in any way recommendations. You should do your own research and make your own decisions – as always.
I got started on this train of thought in my practice when I spent some watching the Berkshire meeting over again, making notes for the points I was too tired to notice the first time around (which went to the early hours of the morning for me). One of those notes was, “Buffett recommends book on 1929 crash, go get it.” So I bought The Great Crash of 1929, by John Kenneth Galbraith, and settled in to read it after dinner one evening.
I do not recommend reading this book before bed. I could not go to sleep that night. As I read about the people buying higher and higher-priced stocks, while earnings failed to justify such prices, and how they planned on someone else to then buy those stocks at an even higher price, my stomach started to feel unsettled. The next day, I still felt anxious.
Reading about the impending misery of our fellow investors isn’t very settling. It is certainly not grounding – and I always want my investing practice to ground me. It didn’t feel good to me. I’m all about investing practice feeling good, happy, joyful. But I forced myself to read this book about the crash of 1929 anyway (though I haven’t finished it yet), and to follow Buffett’s example of facing the stressful events that have come before, so that I can be more ready for it to happen now.
I started to read more ideas about how our current market could crash, to try to avert the danger before it arises. If I don’t get used to this idea now, which, even in a purely academic sense, seems to send my anxiety quivers off the deep end, how will I functionally make it through a real live crash?
With my investing practice hat on, facing the doom and gloom is a lot like buying Practice Shares was for me when I started out learning investing. It’s not investing. It’s practicing an experience. That practice then will take some of the sting out of it, so I can be more present when and if it happens in real life.
A Practice Crash. For when/if our worldwide recession stops being suspended in animation and suddenly starts fully animating.
I’ll also add that if you’re not connecting to this anxiety and fear that I’m describing at all, go get that book and put yourself in the place of the people in it. I find, in my experience thus far, having talked to many investors now, that investors who feel no particular worries about a downturn and, therefore, have never prepared for it or practiced it get hit the hardest when things go down because they didn’t think it could happen to them. It’s the shock that gets them more than anything.
2. Will the Banks Collapse?
I linked to this article in The Atlantic by Frank Partnoy a few issues ago, saying I wanted to think about it and research it more. Entitled “The Looming Bank Collapse,” there is so much here to tackle.
Normally, when it comes to information coming to light about some secretive hard-to-find assets of a bank, I’d roll my eyes and move on. Huge international banks are SO complicated and definitely fall into my Too Hard pile – and my Too Boring pile.
This article, however, was fascinating. It was also so scary that I couldn’t really roll my eyes and move on. I’m curious to try to figure if its facts are on the right track, or way off?
One of the investing tales, so to speak, that was formative in my thinking was the tale of the real estate collapse in 2008/2009 as written by the great Michael Lewis, The Big Short. Just like, as kids, we have Goldilocks and other fables to help us learn right from wrong, so too do we have investing tales that get into our brains as newbie investors. I can easily call back the fear I felt, and the conscious ignorance, as the market melted down and I was in law school and had no clue what was happening – so years later, when I read The Big Short as I was starting to become interested in investing, I had that “Aha!” lightbulb moment about 17 times as Lewis narrated what had happened.
Partnoy’s article says it could happen again. This time, I’m on the other side. I’m not ignorant. You’re not ignorant. If this is for real, we should know about it. So, with mega awareness that I was outside my circle of competence, I dug in. Luckily, the internet has many experts. Which ones we should take seriously is always the challenge, of course, so I gave it a shot.
Investopedia is always my first stop. Essentially, a Collateralized Loan Obligation is when a loan to a business is bundled together with 100-225 other loans to businesses. Sections, or tranches, of these bundles are then sold to investors/speculators, who will be paid out when the underlying loans are paid off by the businesses. Early investors get paid first, and therefore have the least risk; later investors get paid later, and therefore have more risk.
Partnoy describes the structure very well in his article: “Like a [Collateralized Debt Obligation], a CLO has multiple layers, which are sold separately. The bottom layer is the riskiest, the top the safest. If just a few of the loans in a CLO default, the bottom layer will suffer a loss and the other layers will remain safe. If the defaults increase, the bottom layer will lose even more, and the pain will start to work its way up the layers. The top layer, however, remains protected: It loses money only after the lower layers have been wiped out.”
That Investopedia article references a Guggenheim Partners study on CLOs that found CLOs have significantly lower default rates than corporate bonds, mostly because these loans are secured by the collateral of the business and are senior to any other secured loans. The average actual default rate, over time, according to their summary, is 2.8%.
If you take a minute to look at the Guggenheim graphs, however, it’s quite interesting to look at the default and recovery rates in 2009, during the financial crisis – or, in other words, the times defaults might actually affect the system. This was when the collateralized mortgage securities went belly-up, and the overall economy nose-dived, so it makes sense that businesses themselves would have been affected and not able to make their debt payments. Indeed, the first Guggenheim graph “Leveraged Loan vs. High-Yield Default Rates” shows the highest default rate since their chart begins in 1999 in 2009-2010, at just over 8%. A very similar stat to that in 2001 when the dot-com bubble burst. So, there’s a trend here, that when the stock market nose-dives, these CLOs default at much higher rates. The highest default rate on these Guggenheim charts is about 8%. (Note that Partnoy’s article, in slight contrast to the Guggenheim charts, cites the highest CLO default rate at about 10%. 8-10%, close enough.)
The next graph, “Recovery Rates for Leveraged Loans and High-Yield Bonds” shows the recovery around 60% in the dot-com crisis and 55% in the financial crisis. That really doesn’t sound too bad to me. So what’s the problem?
From the source:
“…the banks mostly own the least risky, top layer of CLOs. Since the mid-1990s, the highest annual default rate on leveraged loans was about 10 percent, during the previous financial crisis. If 10 percent of a CLO’s loans default, the bottom layers will suffer, but if you own the top layer, you might not even notice. Three times as many loans could default and you’d still be protected, because the lower layers would bear the loss…But that AAA rating is deceiving. The credit-rating agencies grade CLOs and their underlying debt separately. You might assume that a CLO must contain AAA debt if its top layer is rated AAA. Far from it. Remember: CLOs are made up of loans to businesses that are already in trouble.”
The achilles heel of the mortgage securities in the financial crisis was that the AAA-rated tranches had tons of lower-rated mortgages that were expected to be balanced out by the highly-rated mortgages because they wouldn’t be correlated – but when those lower-rated mortgages were defaulted on en masse, it cratered housing prices overall and defaults occurred in far higher numbers than expected. Turns out, they weren’t as uncorrelated as expected. Furthermore, the credit default swaps exponentially increased the exposure the banks and insurance companies had to these securitized mortgage products and strained them to the point of failure. The Atlantic article is entirely about whether those same circumstances are here in these CLOs now.
Those loans are actually B-rated, and even some are CCC-rated. How do credit ratings agencies get away with putting these risky loans in a AAA-rated security? Um…shades of the financial crisis flicker all over this thing. Here is Partnoy again:
“The answer is “default correlation,” a measure of the likelihood of loans defaulting at the same time. The main reason CLOs have been so safe is the same reason CDOs seemed safe before 2008. Back then, the underlying loans were risky too, and everyone knew that some of them would default. But it seemed unlikely that many of them would default at the same time. The loans were spread across the entire country and among many lenders. Real-estate markets were thought to be local, not national, and the factors that typically lead people to default on their home loans—job loss, divorce, poor health—don’t all move in the same direction at the same time. Then housing prices fell 30 percent across the board and defaults skyrocketed.”
Analogous to a reasonable assumption that businesses wouldn’t default all at that same time, no? Yet, here we are, in a, not just national, but global business crisis that is affecting most businesses. At the same time.
4. Risky Holdings
The risks are there, straight rom the Federal Reserve, on June 25, 2020: “A key question is which investors would face losses if conditions deteriorated further and some CLOs defaulted on their more junior tranches. A challenge in answering this question has been a lack of systematic data of CLO ownership by type of investor and tranche, particularly for institutions other than banks.” They go on to say that insurance companies appear to own quite a bit of the lower-rated CLOs.
The kicker. “To summarize, our new data suggest that institutional investors have sizable exposures to risky CLO tranches. These risky holdings appear to be larger than what market participants believe.” (They ask that the article be cited as follows, so here’s the full citation: DeMarco, Laurie, Emily Liu, and Tim Schmidt-Eisenlohr (2020). “Who Owns U.S. CLO Securities? An Update by Tranche,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, June 25, 2020, https://doi.org/10.17016/2380-7172.2592.)
These risky holdings appear to be larger than what market participants believe. WHAT??!
That’s enough for me to accept that the risk of CLOs is real. The next question, then, is how likely is a mass default situation, analogous to the 2009 real estate market?
It hasn’t happened yet because of government help. Which may or may not continue for long enough (WSJ paywall) to prop up those zombie companies – companies that would have already failed if not for government intervention – until the pandemic crisis is over and they can sustain themselves.
More resources are below in Let’s Get Practical. Enjoy clicking around on this stuff. It’s all about averting the danger for ourselves before it arises.
LET’S GET PRACTICAL:
This article contains a list of bank holdings of CLOs broken down by bank, which is super helpful if you happen to be someone who owns a bank or two and you’re curious about your exposure. (Remember, though, that according to the Fed report cited above, banks mostly hold the top, less-risky, layer of CLOs.)
View on CLOs from the Institutional Investor.
Comments on that Fed report from a wall street blog.
Details on debt in firms from an interesting blog.
If you’re desperately wanting more details about CLOs, here is an entire report from Deloitte about them, from 2018.