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Andrew Park on Loans, the Financial System, and the Economy
A Macro Musings Transcript
Andrew Park is a senior editor at S&P LCD and is one of the foremost experts on collateralized loan obligations and the leverage loan market. Andrew also writes daily on what’s going on in the collateralized loan obligations (CLO) market and his data is the basis for most of the reporting on this topic in the Wall Street Journal, Financial Times, and by many policymakers. He joins the show today to talk about CLOs and their implications for the financial system and, more generally, the economy. David and Andrew also discuss the leveraged loan market, the differences between CDOs and CLOs, and the Fed’s most recent rate hikes.
David Beckworth: Our guest today is Andrew Park. Andrew is one of the foremost experts on collateralized loan obligations, and the leveraged loan market, and is a senior editor at S&P LCD. Andrew writes daily on what's going on in the collateralized loan obligations, or CLO, market, and his data is the basis of most of the reporting on this topic in The Wall Street Journal, Financial Times, and by many policymakers. Andrew joins us today to talk about CLOs, and the implications for the financial system, and, more generally, the economy. Andrew, welcome to the show.
While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
Andrew Park: Thank you for having me, David.
David Beckworth: Well, it's great to have you on. So the CLO, or the collateralized loan obligation market's become a hot topic. You're an expert in this, and we're looking forward to this conversation, but it is kind of an esoteric, very narrow specialty. How did you end up becoming an expert in this area?
Andrew Park: Well, I want to say that timing has a lot to do with it. When I was close to graduating around 2008, I was interning for a number of different banks. When I originally interned at Merrill Lynch back in 2006, they put me on their high-yield desk. That was just very fortuitous because at the time, it was a very active market. That's when we saw a lot of the growth in not only high-yield but, obviously, the mortgage-backed securities market and also the CDO market as we would see in due time. So that was one of the most active desks on there. It was very profitable for the bank, as we saw. That's where they wanted to have a lot of interns so that they could eventually staff up the bank to prepare for all this issuance. I worked there for a couple of years, and then I went on to go to work at a money manager, literally, in June, 2008.
David Beckworth: Really. Great timing.
Andrew Park: Right? Exactly. The timing is, again, very fortuitous. I found myself in the, literally, in the heart of all this right before the financial crisis for the first couple of weeks at my job after I graduated. I went to college at George Washington University in DC. A couple weeks later, I was on a plane to California, and next thing I know, I was working on the short-term money market desk over there. We were looking at banks such as Lehman Brothers, and this is months after we had the incidents with Bear Stearns and JP Morgan taking over them.
David Beckworth: So you saw, firsthand, the run on the financial system, the money markets. Lehman, of course, is a huge catalyst. That's fascinating. You were in the thick of things. You saw the action up front. Were you in a good position? Did you worry about your job at all, or were you secured in your employment during that time?
Andrew Park: Well, it's really funny because the reason why they put new hires on the short-term money market desks is because it's not a market that you have to worry about risk, usually. In a typical market, you lend someone money. You lend someone collateral, and you can reasonably expect it back. But around this time, it actually became a really concerning market. So much so that you had a lot of really senior people at the firm be so hyperfocused on it because all of the sudden you were lending money to Lehman Brothers. Then, closer to September, very senior people at the firm, CIO-level types, were coming to me and saying, "Hey, how much exposure do we have with Lehman?"
David Beckworth: Oh, nice.
Andrew Park: Even in the months running up to that. All of a sudden, you realize this is actually kind of a big deal. From 2008 to 2009, you had, obviously, once Lehman went under, you had all these different programs to help rehabilitate the structured finance market and also the other high-yield market. That's when you had the alphabet soup of different programs out there. Right? Term asset lending facility, TALF, to bring back the ABS, the asset-backed security market. Then I was just, as an employee over there, I was learning so much about this just on the fly. Again, this wasn't something that even senior members of the firm could so much teach as it was just learning on the go.
David Beckworth: Sink or swim-
Andrew Park: Exactly.
David Beckworth: ... in the financial crisis. What a great way to cut your teeth. That's a great story. I have to ask this question. We've had guests on the show where we've talked about the whole Lehman experience. Of course, we discuss it as outsiders. I had, on the show, Larry Ball, who has a book about the Lehman crisis, really good book. What's interesting about the Lehman crisis, there is some debate about how consequential it was. Some say, "Things were going to blow up anyways." Others say, "No, Lehman was the pivotal event." Everyone I've talked to about has more the outside person looking in, making a judgment. What is your sense, since you were actually in the market? You were in money markets, in fact, which is kind of the story where Lehman really destroyed money markets, caused the run on money market funds. From your perspective, was Lehman pivotal or would it have happened anyways?
Andrew Park: Well, part of the issue with Lehman Brothers is that they just had so much exposure to a lot of commercial real estate and also other types of residential real estate that they were bought at extremely overvalued prices. One of the companies that they had exposure to was Archstone. When they ultimately ended up writing that down, you realized that it was way more for what they had purchased this for. It's very similar to when we look at Bank of America back in 2000, before 2008 with Countrywide, where they actually paid money and ultimately spent tens of billions of dollars paying fines and writing down assets. For a while, people were worried that Countrywide would take down Bank of America. With Lehman, you had this issue with Archstone, where they had all this commercial real estate exposure that they were on the hook for. Right? A lot of people in the market were worried about their solvency because of that. As a result, there were rumors flying around as early as August, that I can remember, where people were saying, "What is our exposure to the bank?"
Andrew Park: That was a legitimate concern. You had exposure limits, and people looking to think very consciously about how much ... Let's think about in derivatives, now. How much in CDS exposure do you have, credit default swaps? If you have an open position with them, do you want to switch that to another bank? There is a process where that exists, called a novation, and people really wanted to consider doing this. That's when people realized, okay, maybe there is a concern that Lehman Brothers could be in trouble.
David Beckworth: So you definitely had a sense that Lehman was very problematic, and if it did go under, a lot of other people would be pulled down with it? Was it very ...
Andrew Park: Sure, I mean, if we think about just that derivative example, alone. If Lehman Brothers is your counter party, and they are insolvent the next day, or they have declared bankruptcy, which they ultimately did, there was this big concern after the fact of, okay, well, what is your actual exposure, and what is your claim? Let's say you had an open swaps position with a bank like Goldman Sachs. Then you decided, I will actually close it or I'll have a close to a zero exposure because you have an opposite position with Lehman Brothers. Well, if Lehman's side disappears all the sudden, what is your actual exposure? Right? So in the weeks afterwards, there was a lot of concern about how to go about resolving that.
David Beckworth: Okay. Well, again, very fascinating story. This ultimately led you down the path to where you are now, where you're the expert on CLOs. I want to, now, talk about what CLOs are. Before we do that, I want to step back and talk about the leveraged loan market because CLOs are a part of that. I hear a lot about leveraged loans as well, so could you describe to our listeners what are leveraged loans and how are they used?
Andrew Park: Let's take a step back, now, into the 1980s. Back in the 1980s, we have a very famous financier called Michael Milken.
David Beckworth: Oh yeah.
Andrew Park: Right? He ran his firm out in California, Drexel Burnham. One of the things that would happen is that when you had a lot of these corporate raiders. When we think of people such as Carl Icahn. Right? Ron Perelman, these kind of characters. What they would do is that when they would launch these hostile takeovers of companies, they would, obviously, put these bids for these companies. Obviously, they would fight with the company management. They would run with all these setbacks against them, but if they were successful, that's great. But all of the sudden, how do you finance this? How do you come up with tens of billions of dollars in such short period of time?
Andrew Park: Well, Drexel, through the help of Michael Milken, would then issue these types of securities. Right? He's famous for the junk bonds, now called high-yield bonds, even though they're not really high-yielding anymore. Then, also, alternatively, you have what are now leveraged loans, which is different from a bond. They are a floating rate security, but at the same time, they are usually made to non-investment grade borrowers. That market has grown significantly since the early '90s, where now you are looking at a $1.1 trillion market.
David Beckworth: That's for all leveraged loans?
Andrew Park: All leveraged loans in the US.
David Beckworth: Okay. That's fairly large. Now the idea, again, help me understand this, is you're giving loans to companies that already have a lot of debt. Where does the word leverage come in, I guess? How does that work?
Andrew Park: Right, these are non-investment grade borrowers. If, assuming they're already lower-rated to begin with, so we're not talking your AAA companies. We're talking your, again, below BB type of ... I should say BBB kind of companies here. Some of them don't even have that much debt. Some of them end up taking on a lot of debt because they end up getting bought out. Right? If we look at a recent example, such as Staples, where they had a leveraged buyout back in 2017. They went from having little debt to taking on a lot of debt. You can think of a lot of other retailers like that. You can think of Toys"R"Us. You name it, where companies have started with a little amount of debt and all the sudden, through a buyout, or some sort of transaction like that, ended up with a lot to handle.
David Beckworth: So it could come from the buyout process itself, but you could also have a firm that has a lot of debt already. Right?
Andrew Park: Sure.
David Beckworth: That debt gets repackaged and becomes a new leveraged loan? That's a very ... Why is that attractive for a firm to do that, I guess? If you had a lot of debt already on your books, why go through this process?
Andrew Park: When you're talking about selling the debt to somebody else?
David Beckworth: Yeah.
Andrew Park: If we're thinking about who the buyers are of these leveraged loans, you can sell them to a lot of different institutions, but that's quite the process because you have to go out, you go on a different number of road shows, and you're just constantly traveling and marketing these deals. You're just constantly traveling and marketing these deals. You always have to sell. Everyone has all their different reasons of why they're interested, why they're not interested. Let's take this a step further now. What happens if you could create a natural buyer consistently for these assets? We now see that through the existence, from the early '90s, of these collateralized loan obligations.
Andrew Park: What they do is that, and we track the data on this, S&P LCD. They buy up to 60 percent, sometimes as high as 65 percent of all the new leveraged loans that are created. They are a big buyer of this. Right? That's why you always have a lot of scrutiny that comes with that because a lot of people ask, "Haven't we seen this before?" But what ends up happening is that because you have this natural buyer, it helps to reduce the cost of these types of financings, knowing that if you're going to issue a lot of this debt, well, if you already know that you have a buyer out there that's going to buy 60 to 65 percent of this, well, that certainly helps bring the financing in. We're talking about tens of billions of dollars. That adds up.
David Beckworth: Okay, so I'm an organization. I'm Staples. Well, Staples actually is a buyout example. But I'm some organization. I have debt on my books at a high, maybe high-interest rate. I can refinance it, effectively, at a lower interest rate. Is that kind of the summary of it?
Andrew Park: So let's say, what's helpful, is that ... If you're, let's say, trying to sell to 20 different buyers overseas. They can only pay so much for it, as opposed to, in a CLO, they need the assets, themselves, too. Let's think about, from the CLO's point of view. Think of it more as an asset manager.
David Beckworth: Okay.
Andrew Park: If you're an asset manager, how do you make your money? You make your money by growing your assets because you charge fees on them. That's what CLOs are. They are run by a CLO manager. Right? An asset manager who collects fees on a percentage of how much they manage, very similar to what we see hedge funds and a lot of money managers do. On top of that, they also have an incentive fee if they perform very well. For them, they want to also accumulate and issue as many of those vehicles as possible.
David Beckworth: So just to be clear for myself and for our listeners, a company like Toys"R"Us, which had a lot of debt on its books, could turn to a CLO. It could take its securities and package it in a CLO. Now, in this CLO, would it consist of multiple firm's debt or just one repackaging them in slices?
Andrew Park: It's many different borrowers. Usually anywhere between, and they try to diversify it so that you're not so concentrated in one sector or one issuer. We're talking anywhere between 100 to 200 different borrowers. Even within that, you only want to concentrate yourself, they say, typically, no more than one percent in any borrower. Worst case scenario, the company goes belly-up. Well, you're not taking that much of a hit. At the same time, you don't want to expose yourself to a sector because the logic is if something's wrong with one company in the sector, right, the saying always goes, "There's not just only one cockroach." Right? There's concerns that if a company sector goes under, what's wrong with the industry. We see that now with certain industries where people are concerned. Right? The retail industry. You talk about Toys"R"Us. Brick and mortar retailers, oil and gas, commodity kind of firms, they're ... You want to limit, typically, sectors to no more than five to ten percent within the CLO as well.
David Beckworth: So the CLO is a debt instrument that is backed by little pieces, or slices, of a bunch of other organizations feeding their income payments, or their debt payments, to this organization, which then issues the security to CLOs. So CLOs are, at least in theory, are a very diversified, very safe asset. Is that fair?
Andrew Park: That's what the intention was when they were created.
David Beckworth: Okay. Well, we're going to get to maybe some of the concerns about them, but so the CLO, the collateralized loan obligation is a diversified asset backed by a bunch of corporations who have debt that they've refinanced, and they're making debt payments. This very much echoes, or reminds us, of what happened in The Great Recession and the housing boom/bust with mortgage-backed securities and, more precisely, CDOs, collateralized debt obligations. It's a very similar idea. Right? You put all these mortgages together. You make a new security based off of them. It's diversified. If I lose my job, and I can't pay my mortgage, Andrew, you're still paying yours, and everyone else, so it’s diversified. Maybe walk us through what CDOs were and why they were so consequential to the big crisis in 2008.
Andrew Park: Sure, and I think that's going to be very important to highlight here because every time I talk about CLOs or that comes up in discussion, the first thing that always gets asked is, "Haven't we seen this scenario before?" People's memories are still very fresh from “The Great Financial Crisis”, but there are some important differences, and I want to point them out today. Let's go back, now, to the early 2000s. You have the big growth, now, in the housing market. Right around the time, especially of 2005 to 2007, you really had this growth of these subprime mortgages. Right? Mortgages being made to borrowers who otherwise would not have been able to take out mortgages. Now, there's a lot of political debate as to why this was. Some people will point to the Clinton administration and this push to get as many people to become homeowners as possible. We could debate the merits of that, but really what ended up happening is that you had all this encouragement to get as many Americans to become home owners. Right? We're talking about over 70% at some point.
Andrew Park: You have these loans being made to borrowers whose credit's, looking at a FICO score, let's say, under 700. Possibly even under 620, 660. People who aren't really good borrowers to begin with are going into loans, or getting loans from these mortgage brokers. But let's push this a step forward. All of the sudden, you had some bad actors in this industry. So you had, the most notorious example, Countrywide Financial. What do they do? They started, after a while, issuing something called a stated income loan. There, you could walk into any branch, and they were happy to get your business because for the mortgage brokers, they just wanted to issue as many as possible, get the bonuses, get their-
David Beckworth: It's the service fee they made. Right?
Andrew Park: Exactly. For them, they say, "Put on the line how much you make." You had teachers who suddenly were claiming that they were making $300,000 a year, and for Countrywide, they said, "Okay." Normally, this would be a problem but, again, the entire chain was what was wrong here. Now, all the sudden, Countrywide has made all these stated income loans, which were called, at the time, liar loans because many of them would abuse that. Many borrowers did. If they had to hold these on these books, that would be a problem. But they didn't. What they would do is that they would end up selling them to these mortgage-backed securities. Right? We're not talking so much the Fannie Mae and Freddie Mac, but we're talking what's called private label. These mortgage-backed securities would get issued, then.
Andrew Park: Now let's take this a step further. We were talking about who's buying all these corporate leveraged loans. Well, you have these CLOs, well, and this is where the similarity comes in. A lot of people at the time, despite what the narrative of everyone's head being in the sand, you actually had people who looked at these loans and said, "Wait a minute. You put what in these? We're not buying this." At the end of that, you still needed someone else to buy this. Who was that buyer at the time? It was these collateralized debt obligations, CDOs. They would purchase a lot of these mortgage-backed, these subprime mortgages and the ensuing mortgage-backed securities, and then find people to sell those CDOs to, as well. But this is also where the criticism of financial alchemy comes in, right, because the rating agencies, now ... I should note, even though my parent company is a rating agency, I am separate from them.
David Beckworth: Okay.
Andrew Park: What they would say is, "Okay, well if you buy all these securities, even if you take this percentage of losses on them, people at the very top of these securities ..." So whenever you issue, let's say you issue a CDO, you would issue different risk pieces. Right? So, again, let's say you're buying $500 million in mortgages. Now you're going to issue around approximately $500 million in notes as well. It's not going to be around there. It's approximate, but the idea is that you're not selling one thing. You're selling five different classes. Right? Each one has a different tolerance for risk. You have the people at the very bottom who take the very first loss. The moment, right, that the first penny of losses get taken, that first loss buyer takes the hit. But they're making a lot of money, though. They're usually making double digits.
David Beckworth: With the high-yield. Yeah.
Andrew Park: They're making double digits on that, so that's what they're compensated for. But let's say you're a pension fund. Let's say you're someone whose much more risk averse. You want to be buying, what was rated at the time, a AAA security. They're at the very, very top there. The amount losses that would need to be absorbed is much different. The trade-off is, of course, you're getting paid much less. Right? At the time, it was much closer to LIBOR plus 25 basis points, so much lower.
David Beckworth: Okay, so just to summarize, the similarities between a CLO, a collateralized loan obligations coming from the corporate sector and the CDOs, which were coming more from households. The basic idea, again, is diversification. You've got a bunch of people, and their mortgages, and the mortgages are being bought up by these CDOs, and the CDO organizations are issuing these new securities that combine, in a certain way, the income stream from all these different home owners. The idea is, again, it's diversified. If one home goes down in Texas, you got many other homes elsewhere that are still robust, making their mortgage payments, so we should be good. On top of that, you could slice up that security into different risk appetite levels. I guess what's interesting, in looking back, is that some of these securities ... You take a CDO, which again, hopefully it's clear to our listeners it's just a diversified asset. Some of those securities were then taken, along with other CDOs, and repackaged into new CDOs, right, these synthetic-
Andrew Park: That's right.
David Beckworth: ... CDO-squared, CDO-cubed. They were all getting great ratings, at least the ones at the top, right, the top tranches were getting AAA ratings. I mean, in retrospect, was that reasonable in some cases, or was it unreasonable?
Andrew Park: The reason why they got those ratings to begin with, again, was that there were these assumptions that the rating agencies were using. One of them was that the amount of losses that you would need to take would be fairly high before certain rated tranches would take principal losses here. The assumption is that, at the AAA level, you would need so many people below you to take these losses before this happens. But part of the problem is the rating agencies did not really look into what was the actual quality of this collateral. Now, to take a step back here, we said before about these stated income liar loans, those should never have been originated to begin with. So the safeguards were lost throughout the entire chain of production here. Right, plus, starting from the very beginning of the origination, at the mortgage lender down to the banks, where they're incentivized to issue and, again, their incentives are always let's issue as much volume as possible. This way, their bonuses are also very good, too.
Andrew Park: Continued down the line, the rating agencies, there was a little bit of conflict there also because they are also incentivized to ... They make more in fees from a growing market, as well. Some will be very critical of that because of how the business model operates. Right? The issuers pay the rating agency, not the investor, and that's still being debated to this very day. So we lost that safeguard there. But to go back to the point about they just did not look at the underlying asset and realize, wait, how is this being originated. Should this be originated in this way, rather than just focused on the structural aspect of it, of how much in protection does each tranche of this CDO have.
David Beckworth: Yeah, and I think one of the assumptions made back then that added to this, or compounded the problem, is no one believed there would be a national housing crisis. In fact, I remember listening to a real estate radio show. At the time, a lot of shows were flipping homes, investing. The announcer kept saying, this is a great thing, a sure thing because we haven't had a national housing collapse since The Great Depression. So kind of a baked-in assumption is, look, maybe even if there's a regional slowdown, we're good because these things are diversified across the whole country. Maybe some of the assumptions about, like you said, people at the bottom might take a hit, but it's highly unlikely you get to the top. The idea is we're not going to get anything severe enough to get us to that point, but we did get that.
David Beckworth: One thing I, the macroeconomist in me, want to bring out about these things is they were, they had their problems internally but they also had these problems externally in that they were what precipitated a run on Wall Street. Just like you and I have checking accounts, big institutional investors need checking accounts. They can't go to their local banks, so they go to Wall Street,. These, what we call repo arrangements, where big institutional investors like a pension company, they want to park funds but have easy access, pull it out the next day. They could do that. They could park it at Wall Street. They could pull it out the next day, and the collateral were these CDOs. As long as the CDOs were believed to be great, they would park their money and pull it out. It was the equivalent of a checking account for a big institutional investor.
David Beckworth: Just as soon as they lost confidence, these big institutional investors, they ran on Wall Street. They started pulling their money out. They wouldn't roll over their money. What's fascinating is that this is almost identical to what happened in the 1930s, just at a different level. 1930s was retail banking run. This is institutional banking run, so students of macroeconomics note that the money supply collapses in 1930. Look at M2 measure. Well, if you look at a broad measure of money, and some people have done this, it also collapsed. Even though you don't see, at the retail level, a collapse, there was, if you look at all these money assets at the institutional level, there was a collapse in the money supply, broadly speaking. So this was a classic bank run tied to the CDOs, and that's, I'd imagine, the fear that's somewhere lurking back with these CLOs.
David Beckworth: Maybe let's move to the CLO concerns and try to see if they're different or similar to some of the concerns with CDOs. Before we get into that, I want to read two quotes. I have a Bloomberg article titled, "Wall Street's Billionaire Machine, Where Almost Everyone Gets Rich," and it's talking about the CLOs. I want to read the first few paragraphs here. It says, "He has the familiar trappings of the ultra-wealthy: a Beverly Hills estate, a super yacht, art by Rothko and Pollock. But Eric Smidt is a new kind of super-rich. He made his fortune by transforming an old-fashioned business into a giant ATM, an overhaul aided by one of the hottest plays on Wall Street: collateralized loan obligations. Meet the new aristocrats of debt, the people and companies cashing in on a record boom in these once-marginal investments whose relatively high returns have attracted yield-hungry investors."
David Beckworth: They go on and on. Then later in the piece, it says, "Regulators globally are sounding alarms. For the Bank of England's Mark Carney, the surge is reminiscent of the boom in subprime lending just before the financial crisis in 2008. Some members of the Federal Reserve are concerned that high debt levels are making the economy more vulnerable." They quote someone who says, "'The risk is that if a bunch of these get downgraded, many CLOs will scramble to sell,' said Gene Tannuzzo, a fund manager and deputy global head of fixed income at Columbia Threadneedle Investments." Now, that's a very pessimistic take, very much framed from what happened in The Great Financial Crisis.
David Beckworth: Now I want to read a different take from PIMCO. This article's titled, "U.S. Leveraged Loan Market: Plenty of Risk, But Not Systemic," and they go through a lot of things. I'll just give you the punchline. It says, "Given loan market dynamics, size and scope, the diversity of the holders, and the change in the leverage employed across the system, it is difficult for us to envision a scenario in which the leveraged loan market causes the next financial crisis." So two very different takes. I'm dying to hear your big, ultimate take on this. Before we do, maybe we should peel back and look at the specific concerns and then take the big-picture view. What are the specific concerns with CLOs today?
Andrew Park: Right. When we look at the similarities between CLOs and CDOs, we see, again, a non-investment grade borrower. That's where the reminder reminiscent of the subprime borrower that we're seeing. A less-than-high-quality borrower that is issuing a lot of debt, and you have a big, natural buyer for this via this securitization vehicle. Now that's why people are asking the question. You have a lot of central banks, because we've seen that. We've seen the Bank of England. We've seen the IMF. We've seen different members of the Federal Reserve talk about and make these comparisons to the subprime bubble that we saw in 2006, 2007. Again, just this rapid growth. The CLO market, to give you an idea, is now, in the US, is about $700 billion. Within that time span, when we look at what it was pre-crisis, we're talking a fraction of that. We're talking around two to $300 billion.
David Beckworth: So there's been rapid growth, but that's still not like a huge, huge part of the overall debt market. Or is it, is it?
Andrew Park: Well, I think ... I'm just trying to think of how much we have in high-yield bonds. We're now, at one point, have more leveraged loans than high-yield bonds.
David Beckworth: Oh, we do. Okay.
Andrew Park: So they have grown fairly significantly.
David Beckworth: The absolute size is non-trivial, too, then. We're at a point where it's big enough it could hurt. You list, though, in some of specific concerns with it. Maybe we've touched on these, but let's just be precise. Let's go through. You mentioned covenant lite. What is the covenant lite problem?
Andrew Park: Again, now, when we talk about what was wrong with the mortgages, they were not underwritten very well because you weren't even looking at how much people were making.
David Beckworth: Okay.
Andrew Park: You just took assumptions on their face, and you ran with it. Well, now with covenant lite, the issue is what are your protections as an investor, suddenly. If the company does something that you don't like, what can you do against them? To give you an idea ... I was talking before about how CLOs need leveraged loans. Right? Because, again, if you're collecting fees on this, you want the asset class to grow as possible. So now, question now is if you depend so much on how much in leveraged loans are getting created, then how much pushback do you, as an investor, really have? The assumption usually is that as an investor, you hold the cards. If you don't like something, you can push back against it. But I think one of the best things I heard is that one of the biggest causes of bubbles, sometimes, is watching your neighbor get richer than you. In the CLO market, if you're seeing some guy issuing five deals, and you're only issuing one, then the question is, do I need to be catching up to him?
Andrew Park: What's happening is, a lot of times you're really dependent on acquiring as many assets as possible. What's happening is people have not been pushing back on less covenants being inserted in these deals. They're called maintenance covenants. What that means is that if the borrower starts to take on too much leverage, then you need to push back on them, and they need to pay you more. What we've seen, based on that dynamic, is that today 80 percent of the loans that have been issued are what's known as covenant lite. That number has not been that way. When we look at, even just back to 2014, that number was only about 20 percent. So it has grown very remarkably ... The entire leveraged loan market, at this point, is now covenant lite.
David Beckworth: And the motivation for this, you just mentioned that if you don't do it, you lose market share.
Andrew Park: Sure.
David Beckworth: I mean, if you're issuing CDOs and you're not compromising your standards, well, the next guy's going to do that. That's kind of the story in 2006, 2007, right, that ever from the mortgage originators ... If you didn't issue a mortgage to the people with low credit scores, and someone else would, all the way up to the pushing on Wall Street buying the CDOs. It was a complete breakdown of norms because it was a race to the bottom.
Andrew Park: Yeah, well, not even that, Dave. At a certain point, you've ran out of mortgages to securitize. So much so that all of the sudden the banks started issuing synthetic mortgages. That was how much demand they needed to build up these vehicles to collect more fees on. Right? That's why you, literally, would, instead of issuing the actual mortgage, you would issue a credit default swap on a non-existent mortgage. More or less, basically, instead of issuing one, you would literally just create a security from scratch.
David Beckworth: Right, and so you're saying at least a little bit of that spirit, that frothy spirit, is evidenced in the CLOs market.
Andrew Park: Mm-hmm (affirmative).
David Beckworth: Okay. And that's, you can see at the covenant lite. Now, how about accounting tricks? Any accounting tricks going on to make this happen?
Andrew Park: Yeah, so that's where the other area of concern comes from. Where, again, when you have stated income back in the day, those numbers were nowhere close to right. If a teacher claims that they're making $300,000, that's the information that's going into the data all the way down the chain.
David Beckworth: Okay.
Andrew Park: So if that's inaccurate, then what can you trust? The challenge here is that ... Now, let's go back to the process of a buyout. When you conduct a buyout, you are valuing the company at a multiple of their earnings. As we know, there are different ways you can measure earnings. One of them is called EBITDA. Right? Earnings before interest, taxes, depreciation, and amortization. The thing with that number is that it is not what's called GAAP number. It's not necessarily, when you look at accounting principles, there is no necessarily standard way to look at that number. People have a lot of flexibility around that. Right? But the issue here is you have all these buyouts occurring. In the last couple years, it's been a lot more challenging to do these kind of buyouts because you're competing. Equity price, stock prices are at historical highs in terms of multiples, and you're competing against, let's just say natural buyers in the space.
Andrew Park: If you're a private equity firm and you want to win, you're going to pay a good multiple to win the business. Let's say you're paying a decent-sized multiple, let's say you're paying 12 times the earnings. Well, how are you going to ... You're going to have to finance that. In order to make that number work ... That 12-times number, that's a decently high number, especially when we look at what it's been historically, which has been in the high single digits. Suddenly, when you're paying that kind of number, you need the financing to justify that. Well, if you come to market with a very high-leveraged deal, people are going to say, "Oh, no, no no. I don't want that." How do you go about that? You make adjustments to that number. That's what we're seeing right now. We're seeing something called EBITDA add backs.
Andrew Park: What's happening is that you will play with that number so that you will, in order to make the numbers, the financials more tolerable for the investors. You recently had the head of buyouts at Bain Capital recently give an example about this because he was speaking to the FT. This is Jonathan Lavine. He was saying, the example that he gave, was that let's say you're 5'8", and you want to pass yourself off as taller. Well, you will do whatever adjustments you need to become 6'2", right, whether that entails standing on a box or maybe even stretching yourself. We're seeing a lot of companies do that. How do they do this? They will say, "Okay, well, after we successfully buy this business, there are cost savings to be made."
Andrew Park: Right? We've seen this. This is why sometimes private equity gets a bad rap because they conduct layoffs or they say ... The dreaded word they use is synergies. Right? They say, "Oh, when we combine these two divisions, maybe we don't need two accounting people doing the same thing. Maybe we don't need people who overlap with each other, so we'll save money that way." But the question is, how much of that actually gets realized? People have done studies on this and found, okay, well maybe there are not as much cost savings as you realized. Actually, your debt will be higher. Your leverage will be higher.
David Beckworth: All right, so we've been talking about the challenges, some of the temptations that have taken over some of the CLO market. Can you give me some specific firms that have been a part of the story?
Andrew Park: If we look at ... Let's take a look at a company such as J. Crew.
David Beckworth: Okay.
Andrew Park: I think it's important to look at this company because we're looking at one, a company that's been, or a sector that's been secular decline. Right? I mean by now people have been talking about brick and mortar, how everyone wants to shop online now. In this instance, J. Crew has been seeing sales declining for many years now. For the private equity firm that purchased them, suddenly they realize, okay, well, profits are declining right now. How are we going to go about resolving this? We talked before about covenant lite. Well, one of the things that we saw happen was that suddenly there was a new entity that was created called an unrestricted subsidiary. This was formed offshore.
Andrew Park: The intellectual property assets were suddenly paid out as a dividend to this new entity, which is a problem because if you're a bond holder or you're a loan investor, if you have to go to court, you no longer have claim to those assets. This became a big deal. People realized, what do we actually have? If we don't have these covenants in place, then what can you do about this? There's now a term that goes around in the leveraged finance market because of that because that set a precedent. It's called getting J. Crewed. That's what happens when you don't watch for this.
David Beckworth: Nice.
Andrew Park: This is a concern, and this is why, and, again, examples like this ... We also saw this with another retailer with Neiman Marcus, where they had one of the more profitable parts of the business called MyTheresa that also got shifted into an unrestricted subsidiary very similar to what happened with J. Crew. What happened, in this instance, is that you noticed the private equity buyers will find ways to protect themselves first and to pay themselves first rather than protecting, in a normal environment, the investors who are the most senior on this.
David Beckworth: Okay, so there are real concerns, real things happening in the CLO market that are troubling. Do these amount to systemic risk? I mean, are they going to rise to the level where we could see another financial crisis?
Andrew Park: I'm going to say, "No," on this. Now, despite all the things that are concerning, it's important to say, "Well, what's different right now?"
David Beckworth: Okay.
Andrew Park: Well, when we look at mortgages back in 2007, part of the issue was that there was no underwriting whatsoever. Right? You could literally walk in and you could claim what your income was in this instance. There was other safeguards that were not put into place, as opposed to corporate borrowers, you have the assurance that they are audited. People will question, well, what is the quality audit, but they are audited corporations. They have good access to more borrowing if they ever run into trouble. Right? That's why we see the whole bankruptcy process with the Chapter 11, where they will end up getting financing. That's the first part. The other part here is how much risk are the different institutions taking? So, banks ... If we look at what happened in 2007, to go back to the process, now, of how do you create a CDO. You don't just create one overnight. Right? You gradually create it.
Andrew Park: What the bank does is they issue something called a warehouse. What they do is that during that process, they gradually accumulate assets. Right? During that process, usually they are ... They take the risk holding that on their balance sheet, historically. What would happen in 2007 that became such a problem is that when the CDO market shut down, all of the sudden they had all of these warehouses opened that had all these mortgages still sitting on them, and they say, "Oh no. What do we do?" On top of that, those underlying assets were falling quickly in value. That's what you saw in 2007.
Andrew Park: What's a little bit different today is that you now have ... Now, the banks still have these warehouses that they're doing, but they now have other investors that take that risk now. Worst-case example is that, now, let's say that we run something similar to that where these corporate leveraged loans are taking a big hit. Well, it's not going to be the banks that hold it. It's usually going to be some asset manager or specialty firm that holds what's known as the first loss risk on that. So that's a major difference. The amount of exposure that the banks have to this asset class is much lower than what we saw pre-2008.
David Beckworth: Now, I mentioned earlier the CDOs were tied to the repo market and also the asset-backed commercial paper markets, so the short-term funding markets. Are CLOs also tied to short-term funding anywhere, which could lead to a run?
Andrew Park: No. That's the-
David Beckworth: That's a huge difference, then. Right?
Andrew Park: That is a big difference. Right? So when you talk about, right, the asset-backed commercial paper, this was, and a lot of people realized the problem with this. You're issuing 30-day maturity, 30 to 90-day maturity paper, and suddenly if that investor disappears, then you don't ... Right? Then all of the sudden, where's that buyer coming from? Well, now who are you selling to? You're selling to institutions up and down the capital structure. People have realized these are more buy-and-holds type investments. Not everyone, I mean, you do have shorter money like hedge funds who come into the space, but you have a much more stable buyer base now. Now, people say, "What happens if that buyer base disappears?" I mean, that is a real risk. I mean, these are not risk-free assets. You do have those kind of risks. But, again, at the very top, and this is why you also have a little bit of concern, you have banks buying at the very, very top.
Andrew Park: Now, what's very different here is that, again, going back to haven't we seen this before, with mortgages, again, if house prices are falling in California, chances are, we realize they would actually be falling across the country. Why? Because a lot of people were getting mortgages that they shouldn't have to begin with. That's a little bit different from corporate borrowers, where they're always going to be taking on different amounts of debt. So if you have one sector that's going down, and we saw that in 2016 with oil and gas companies. You still had other companies that were doing just fine. Software companies, other types of what they call business services that were still doing just fine. You still see that diversification. That helps.
David Beckworth: Okay. Well, that's a very reassuring message, Andrew. Thank you for helping us feel better. It's really great to hear that it's not tied in any meaningful sense, or largely to a market that can be run on very easily. So that's a big, big difference. Now, one other question that comes to mind is what role does the central bank play? What role has global QE played? Any thoughts there?
Andrew Park: Yeah, so this where a lot of the central banks, then, get a lot of criticism. The most, I mean, we obviously see what the Federal Reserve has been doing, but the pioneer to all of this has been the Bank of Japan. They just recently celebrated their 20 years of zero interest rates. Right? They have been the pioneers of this following the big real estate crisis that they went through before we did. What they did is, right, they've lowered their rates to zero percent and to negative in some instances. Now, this has proved to be a big problem for the banks. As a bank in these countries, how do you make money if all of the sudden you can't pay zero or negative rates to your customers because then who ... That just flips capitalism on its head. Who's going to put money in a bank if you're not going to get compensated for it? Or worse, if you pay a negative rate to it? Everyone is, literally, going to put their cash in a mattress.
Andrew Park: They can't fix that, but the problem is, they're making no money on their investments domestically. Right? Japanese government bonds, if you look at those, have a negative yield. What they have been doing is they have been one of the biggest buyers, in the past two decades, of overseas assets. The Bank of International Settlements has calculated this. It's about $4 trillion that they have been investing anywhere else in the world.
David Beckworth: This is Japan as a whole, or…
Andrew Park: As a whole. Right. They have been investing, or institutions there have been calculated to invest up to $4 trillion in assets. That's why you see them invest in emerging markets such as Turkey or, in this case, this gets to my point now. What is the highest AAA rated asset that you can buy? Well, that is going to be CLOs. Some of the banks there have been some of the biggest buyers of that. I'll give you another idea, too. There's been so much demand for US dollar denominated assets that now ... A lot of the banks, what they have to do is they have to hedge their currency exposure.
Andrew Park: Well, once you do that with US Treasuries, that yield since October has been negative. Suddenly, they realized, okay, well, we can't buy US Treasuries. What else are we going to buy? They've been doing this for a couple of years now. They realized we need to buy more CLOs. There's been a check, now. One of the banks there has issued ... Now, I just told you the CLO market is about $700 billion, and globally closer to 750. One bank over there who manages money for farmers and fisherman recently reported that they hold about 62 billion of CLOs.
David Beckworth: Wow.
Andrew Park: If you think about that, that's nearly ten percent of the entire global CLO market.
David Beckworth: Now, this does have echoes back to the 2007 crisis because part of the story there is there's this safe asset shortage around the world. People want to hold safe stores of value. You run out of Treasuries, well, Wall Street says, "Hey, I can provide another safe store value called a triple rated CDO, CDO-cubed, or whatever." But this is a similar thing. There's only so many Treasuries, so they go to the next-best alternative. Apparently CLOs is filling some of that gap. But, again, we don't have all the systematic properties we had with CDOs, so it's a little different, but it is similar in a sense that there's this global appetite for safe assets and they're returning to CLOs as one potential solution.
Andrew Park: Right. And so, yeah, again, the major difference here is that the underlying asset class ... I'm not here saying it's great by any means. As I mentioned to you with these concerns about taking on more debt, higher leverage, and these different accounting tricks that you're doing with the EBITDA add backs, there are definitely concerns there. That's why you are hearing a number of central bankers and other government officials raise these type of issues. It's definitely a debate worth having, but, again, when you look at the actual quality of the loans, you don't have to worry about, unless there's widespread corporate accounting fraud, à la Enron, which ... There will be one here, ones here or there, but, again, you would need that to happen at a widespread level for us to start to see what you would need to see in 2007.
Andrew Park: On top of that, too, right, you don't have this widespread concern of the auditing part of it. But let's also look at how did ... We had CLOs back before 2008 as well, how did those do? When we actually look at the data behind it, we actually find out, okay, so corporate borrowers actually held up pretty well. In the structure, there has never been a default under the AA rated tranche. The structure has, historically, held up very well. Even below that default, the amount of principal losses that those securities have taken above the non-investment grade tranches are still fairly limited, you don't really have too much of them because, again, the structures are built in a way to ... Again, they know that losses are inevitable. These aren't built with the rosy assumptions that everything will always be fine. They realize times will be tough one day, and so there are mechanisms in place. I think that are just maybe far too nuanced to discuss here, today, but that will either deleverage the deal or protect the investors above them.
Andrew Park: The structure's held up, and now the criticism is based on what I was mentioning before about the accounting tricks. Losses will be higher this time around on those CLOs. They will be, but again, the question is will they be above some of these lower investment grade tranches? A lot of people, even people who have really been involved in this market are not really concerned about that. That's why you have investors such as PIMCO that you were citing before. They've been in this market for, since the beginning. They're saying, "Look, while there are things to be concerned about, but these are not going to be widespread. It's not going to be systemic because, again, people are aware of these risks." That's not to say that won't lose money in them, but again, you're not going to see the financial stuff taken down because of what's going on with leveraged loans and CLOs today.
David Beckworth: One final question in the time we have left. That, again, goes back to monetary policy. That is the Fed's policy from last year to this year, there's been a pivot, quite a big change. The Fed was talking rate hikes. Even in December, was this big rate hike that some are now saying was a mistake. Let's call it the Jay Powell head fake. Has this had any bearing on these debt markets?
Andrew Park: Definitely. One of the things with this asset class about leveraged loans and CLOs is that they're floating rate. That's important because the coupon is off of the LIBOR rate. For a while, one of the big marketing pitches was that, especially to a lot of these overseas investors that I was just talking about, is that, hey, when interest rates go up, that's good for you because your yields are going to be higher as the LIBOR rate goes up too. That's been good for a while. Well, all of the sudden you now have the Fed saying, "Wait a minute. We may not be increasing rates for the rest of this year." Suddenly, that narrative has completely been taken away now, and so investors are saying, "Well, why do I want to buy a leveraged loan versus a high-yield bond, which pays a fixed rate coupon?" We've already seen that shift already. Right?
Andrew Park: We've seen a lot of funds that say, "Hey, we're investing in leveraged loans," see a lot of money getting pulled out of them. To give you an idea, since October, we have seen 20 straight weeks of outflows for about 24, $25 billion because people have lost faith in that narrative that they will get more in returns for that. This compares, during that same time span, we've seen inflows into high-yield bond funds. Right? That's making it quite evident.
David Beckworth: Okay, substitution into the junk bonds, okay.
Andrew Park: Exactly. You still want exposure to the high-yields, but you just want to do it in a different way. We're seeing that right now. For CLOs, they now have the challenge of, okay, well, do people still want to buy this asset class as much. Right? So to your point earlier, what happens when buyers disappear or step back? We're seeing that a little bit right now, and so the market is a little bit slower. The market is definitely a little bit weaker as well. But again, to emphasize the point of all this is this systemic? No. I mean, again, you will always find, right, markets go up. Markets go down. We'll find that they will rebalance over time. We're seeing signs of that, again. Some managers will not perform well. Some will take losses. Will that take down the financial system? No. You will see some that drop out, some that will have to sell their platforms, and some that just don't do well. That's fine. That's just how things work like they do in the hedge fund world or in the asset manager world.
David Beckworth: Well this good. Maybe Powell's head fake is a good test run or robustness check for the CLO market. It gives them a chance to kind of test the waters of funds being withdrawn. Maybe issuers may learn from this and build up more firm infrastructure. One final, final question. I know I said the last one's the final, but let's make this the final one. If you do want to get out of that market, let's say you have invested in CDOs. Is this like a liquid market where you could sell your CDO to someone else, or do you literally have to just liquidate, take a loss? How does it work?
Andrew Park: That's where it does get a little bit challenging. I think one thing that most veteran practitioners of this market will say is that these are not short-term instruments.
David Beckworth: Okay.
Andrew Park: They're very volatile, and I think that's a point that does need to be mentioned. Over a short period of time, when the market does not look good, like we saw in December of last year or in 2016, they can look pretty ugly. But there's one key thing that also I need to emphasize about how a CLO works is that when they are issued, they lock in debt for five years, about. During that time frame, as long as you don't take losses on that, right, I mean realize actual losses, you will be fine at the end of the day. And we saw, to give an idea, back in 2016, half of the CLO market showed they had a negative asset value. Right?
Andrew Park: That was a big problem. If you look at that, you say, "Well, that's a big problem." Well, ultimately, today, all of them are closer to being above water now. Again, it's because you have that five years of borrowing where no one can pull money on you during that time frame, they are a little bit stable. Now, this is different from if you are an investor buying a CLO, and you want to sell it. Well, it's going to be pretty hard when the market's not good. Right? The saying goes, "Liquidity is not there when you seem to need it."
David Beckworth: Right, right. That's true.
Andrew Park: That's why they say, if you plan on holding it for a long period of time, the vehicles are designed to be able to handle market stress. That being said, if you just want to buy, hold for a few months and sell, it's probably not advised. Again, that's something that people need to be conscious of and also for, there's a lot of publicly traded funds that offer exposure to that. Know that those prices will be volatile. But at the end of the day, as I mentioned before, historically the asset class has held up. Their expectations, they may not be nearly as good as they did back in 2008, but, again, they still will do okay. They will not take down the world and the financial system.
David Beckworth: Okay. Our time is up. Our guest today has been Andrew Park. Andrew, thank you so much for coming on the show.
Andrew Park: Great. Thank you so much, David.
David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. While you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.
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