Is the credit bubble about to burst again?


The annual meeting of the World Economic Forum at the plush Swiss ski resort has long been a focal point for markets. In years gone by, high profile business leaders, politicians and economists have dominated headlines, but this year, in the absence of Trump, XI Jinping of China and Vladimir Putin, the conference was somewhat lacking. Even Theresa May sidestepped the event, sending Phillip Hammond in her place. 

 

Unsurprisingly, there was growing concern about Brexit. Hammond’s message was that the outcome of the referendum should be respected but a no-deal Bexit would betray those who voted leave in hope of a better future. Sterling has reacted positively in anticipation that the ‘no-deal’ scenario is becoming less and less likely (currently around 15% according to the betting markets) although the uncertainty about what happens next, looks set to persist beyond 29th March. 

 

Of greater interest was the general sense of caution that replaced the optimism of last year. Bridgewater’s Ray Dalio warned of a significant risk of a US recession in 2020 and was equally cautious about the prospect of a slowdown in Europe, China and Japan. Barclays CEO, Jes Staley, went one step further and said that another financial crisis is more or less inevitable.

 

Staley cited renewed growth in the CLO market following the last financial crisis. In the US, where the market is significantly bigger than in Europe, we’ve seen steady growth of new issues since 2011. 2018 saw a new record of $125bn in new issuance, surpassing the $123.6bn in 2012 according to LPC Collateral data.

 

 

Critics will argue that unlike the CDO market (where the underlying assets were primarily sub-prime mortgages) CLO vehicles comprise of a combination of credit card debt, car loans and student loans. The market is also very different to that which triggered the financial crisis in 2008. CLOs are divided into various levels of risk. Of the 4,322 CLO tranches that have been rated by S&P Global Ratings before 2008, only 38 tranches across 22 CLOs have defaulted while there has never been a default in a AAA rated tranche.

 

Another important factor is that the holders of CLOs are no longer the investment banking arms of high street names which the public rely on to provide borrowing facilities. Tighter controls in the traditional banking system, including smaller balance sheets and requirements to hold more reserves against potential future losses mean that the banks are no longer exposed in the way they once were.

 

Instead, CLO managers investing private capital are the major buyers. One concern is that as the market has grown, credit quality has deteriorated with many of the underlying loans being covenant light. Secondly, with less regulatory burdens, CLO managers have more flexibility over what they invest in and in an attempt to generate higher returns for investors, managers are being forced to take more risk with second-lien loans which rank lower in the capital structure.

 

As we near the end of the cycle, noting that we are now more than ten years on from the financial crisis of 2008, every market commentator is trying to second guess when the downturn will come and what the trigger will be. Aside from volatility in the equity markets towards the end of last year, there doesn’t appear to be any sign of distress at this stage. However, that’s what everyone was saying at the end of 2007…

 

Author: Marc Cogliatti



 

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