Here is a Wall Street Journal article that is simply meant by me to pass on items I find today–of interest to me, but maybe not to you.
The article deals with structured finance, including CLOs (collateralized loan obligations). Given that I have exposure to this sector I like all opinions.
Here it is. It should be accessible to all.
Great discussion. I would only note that it is important to look at the Assets backing these securities.
There is a big difference between Mortgages, Credit Card Receivables, Car Loan Recievables etc and Sr Secured Bank Loans.
There is also a big difference between Sr Secured loans made to small businsess compared to large cap corporations. BDCs focus on the former.
It is easy for a homeowner or a CEO to hand back the keys to a building.
Is not so easy for a corporate CFO to default in a secured bank loan.
FWIW.
What does all this mean for supposedly AAA credit ETFs like JAAA, ICLO, and HSRT??
Not exactly sure what you’re getting at, RMH, but it sounds as though you’re thinking “What me worry,” I’ve got AAA credits in these ETFs. A lot of the worry comes from the long memory of people and what happened to the similarly named and similarly rated CDO’s in ’08.. . Certainly there have been a lot of changes to the structure because of what happened back then and also at the agencies so as they do not fall into the same trap again… But are the changes failsafe? The comparisons are too eerie not to think it could happen again and AAA be damned. BTW, I do own JAAA in small amount.
https://www.cbsnews.com/news/the-aaa-meltdown/
[NOTE: The article is dated 12/6/2007]
“THE AAA MELTDOWN….At the heart of the subprime mortgage fiasco is a financial instrument called a Collateralized Debt Obligation, or CDO. A CDO is a collection of bonds that’s divided into tranches and then sold to investors. Usually there’s a AAA tranche at the top (very safe, very reliable) and a garbage tranche at the bottom (pay your money, take your chances). In the middle is a mezzanine tranche.
It’s easy to understand why the garbage tranches have lost all their value: they’re garbage. But why are the AAA tranches also losing value? Aren’t the underlying securities still safe and reliable? Today, Steven Pearlstein puts in place a piece of the puzzle that I didn’t know about before:
The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.
Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.
It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees….What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.
One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.
So if this is right, then the reason that even AAA tranches are in such trouble is basically twofold:
A lot of the AAA debt isn’t really AAA. It’s mezzanine debt that the rocket scientists and the rating agencies conned everyone into believing was AAA.
The mortgage meltdown is so widespread that even the legitimate AAA stuff is taking a beating.
Put these two things together, and the average AAA tranche is overvalued by, say, 10-20%. Add in the usual Wall Street panic whenever something goes wrong, and buyers are demanding discounts of 20-30% or higher.
There’s plenty more worth reading in Pearlstein’s column. But here’s the unsettling conclusion: “This may not be 1929. But it’s a good bet that it’s way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.””
Hmmm. They said the same thing about bank loans a few years ago. There was article after article about covenant-light terms and junk borrowers. Bank loans have performed quite well since. Same thing for the regional banks after the 3 debacle bank failures of 2023. Since then banks and their preferreds have done quite well.
As for 2008, there was fraud at every level. Borrowers knew they couldn’t pay their mortgages, lenders knew the borrowers couldn’t pay the loans, regulators let it happen, Wall St sold it to the world, and rating agencies told us the crap was AAA.
So, while I understand the concern and it does rhymes with the past, no one is defining exactly what the problem is other than it’s “private credit” and it’s “hot”. I’ve not yet seen anyone answering the question that I posed.
I think I’m essentially in your choir…….
My problem is that the underlying bonds that make all this stuff up seem overvalued.
If you buy 100 bonds, at par, overleveraged and (often poorly managed) companies that yield 7% and the default rate rises to 5% you make 2% to hold a very risky portfolio.
Why not own T-bills and make 4%
First of all, this is a great discussion. I own many of these supposedly AAA CLO ETFs, but other than the ETF fund literature, I can’t seem to find a whole lot of in-depth analysis if this is all good stuff or just another 2008 debacle-in-the-making.
The premise of ETFs like JAAA and others are supposedly that they hold AAA credits. So, while the private market is heating up and there is “over-leverage”, how does that apply to these specific ETFs?
You say the bonds are over par. But these are not bonds, they are CLOs. Where do you find the price for these? Here are the top 9 holdings of JAAA which only represents 7%:
OCP CLO 2021-23 AR
Octagon Investment Partners 51 Ltd
Magnetite XXXIX AR
Ares LIII CLO A1R
Balboa Bay Loan Funding 2021-1 Ltd
RAD CLO 21 A1R
Madison Park Funding XIV AR
KKR CLO 35 AR
Carlyle U.S. CLO
Better check the logic of your math, Dan…. If you have a CLO that yields 7% and it starts out with no defaults (and for simplification sake each item inside the CLO yields exactly the same thing), if the default rate rises from 0 to 5%, then don’t you theoretically get 95% of 7% in returns [ignoring the impact of, and probable huge impact of whatever leverage they might have for the sake of illustration]?
Well no because you lose principal for each default, in addition to the loss of yield. My math is simplistic because it doesn’t take recovery in bankruptcy into account (50% or so if the market isn’t stressed and considerably less if it is).
Dan-
I believe the figures I’ve seen show that the default rates on CLOs in general are lower than that, and for the AAA are a small fraction of a percent- almost nil. What is the 5% based on–CDOs?
I just sold most of my exposure to leveraged loans last week (and in all its derivative forms like CLOs, BDC’s etc.). IMO “private credit” and “structured finance” fancy renaming of risky, junk rated bank loans being rehypotheticated, repackaged and resold with even more leverage! It did well during the massive expansion in the supply of money and credit following the GFC.
With the underlying bonds themselves now trading at or above par and yielding in the mid 7’s the spread simply isn’t attractive to me anymore. Good market to sell them into now. Can pick up on sale in the next crisis.
Also:
Paradoxically, by late 2024, the U.S. leveraged loan default rate climbed to a decade-high of 5.6%, driven largely by distressed exchanges. That rate surpassed the previous peak of 4.5% seen during the COVID-19 crisis in 2020.1 However, the rise in defaults generated little concern among lenders, who remained ebullient.
Default rates mentioned in news stories on specific lenders far exceed what I remember of the default rates advertised in the CLO ETF marketing materials. Some commenters recommend buying lower rated CLO ETFs as risk free or risk rewarded. (From Bloomberg 2/21 on one CLO lender – “The serious delinquency rate for Arbor-issued CLOs jumped from 3.8% in December to 7.8% in January…”)
No CLO ETFs yet. I like the concept of bundles of quality loans. Getting 6%+ instead on 4% on MMFs sounded great until the 6% started melting away. Watching the paradox of falling distributions and rising NAVs. Commenters say the JAAA Feb. drop was a one-off event. JAAA should shed some light on the mystery tomorrow. JMO. DYODD.
Bear, in my area shopping centers seem to be doing ok. The couple owned by Simon property group seem to be doing better but they still have anchor tenants that are the walking dead like J.C. Penny and Macy’s who is close to needing life support.
Not sure spreading the risk around with a ETF is going to be any help with CLO’s Maybe an ETF for reit’s?
Peter Lynch : di-worse-ifi-cation
No sure if anyone read the link I posted on CHS merging with the Minnesota ag co-op but on the CHS website they mentioned farmers were going to plant more soybeans this year to sell for oil. Which is what Cargill and ADM are into making seed oils. The caption mentioned that after processing they hope to sell the meal left from making the oil to feed for animals. I wonder if the export market is going to be there for that.
I think with all the tariffs talk the farmers are facing a lot of uncertainty.
CHS
– Seed oil health controversy – farmer and Senator vs health influencer and cabinet officer face-off over seed oil for cooking. Senator expects to win,
– Farmers are nervous about reduced grain export sales but expect a bailout, like last time according to one Ag site.
– IMHO, if grain backs up and prices fall, poultry producer margins should benefit from cheaper inputs. Pundit Navellier told Bloomberg-he is a CALM buyer.
– The other oil: CHS refinery earnings are weak, tariffs likely hurt. Good news is the latest guess is only a 10% tariff on Canadian crude.
— Not really expecting much impact on CHS preferred. Don’t follow ADM or Cargill, Long: 2 more boxes of oat squares, JMO, DYODD.
Thanks BearNJ. Like you I don’t expect real movement in CHS preferreds–BUT I will buy more if there is movement lower.
Thanks Charles for mentioning this.
Following up – first installment of farmer bail-out money going out, 10 of 30 billion. No tariff bailout yet – this compensates for high input costs and loss of market share to competitors. (No mention of China which has positioned itself for a trade war by greatly cutting US soy imports while increasing domestic production and SA imports.) Not all bad news for the US: the drop in US soy exports is attributed to increased US domestic use. Long: Ag. JMO. DYODD.
US Farmers to Get First of $30 Billion Tranche for Downturn
https://finance.yahoo.com/news/us-farmers-first-tranche-30-005932785.html
If anyone else is paywalled,
https://archive.ph/h6fbA
O. Chongusu
Thank you for posting the archive link. It confirmed a lot.
You can run, but you can’t hide. If they have this event in Vegas next year someone needs to drop a giant can of Raid on these cockroaches.
Someone at the S.E.C. already sees smoke when they sent out the letter to State Street & Apollo advisors about their new Private credit ETF
https://www.reuters.com/business/finance/us-regulators-unusual-move-raise-concerns-about-new-private-credit-etf-2025-02-28/
Too bad someone in the government is trying to dismantle the guardrails at the S.E.C right now.
I knew 15yrs ago when we heard the government was rescuing investment bankers by backing buyouts and mergers to other banks like B of A and Wells Fargo and no one was prosecuted or went to jail that managers who worked at places like Countrywide would end up with jobs at other places and rotten apples just turn the rest of the apples in a barrel rotten.
Everyone needs to take the time to read this article.
Well what are you going to do? I have been sour on Private Equity for a while. We know they have been buying up insurance companies, Why? my guess is to load them up with structured finance bonds telling everyone they are safe and its the way they earn income to payout retirement benefits in the future.
Dan’s comments about CLO companies and their part in the leverage game makes you think.
Makes me want to ask my local Credit union what their percentage of loans is non performing.
The same thinking that got the bond market in trouble in 2008 is still around. Spread the risk around by packaging asset backed mortgages into bonds so if some fail the bonds are still good.
Same idea, but now they are taking loans backed by everything from golf cart, plastic surgery, credit card debt into bonds if I read this right. Maybe even packaging shorter term loans like this with longer term loans like borrowed money to build data centers and saying the mix makes the overall bonds safer.
Here’s the funny thing, I’ll bet there are already Vultures (excuse me, traders) standing by to short this and to go through the mess afterwards buying the bonds pennies on the dollar to strip out the good asset backed bonds.
“Makes me want to ask my local Credit union what their percentage of loans is non performing.”
I do this with every CU where I was on the board or committee, and every CU where I now have money, every quarter.
Perhaps not oddly, I’m not on any CU board or committee now.
I realize it’s tangential but CU’s are struggling with the application of CECL, which was implemented for non public FI’s in 2023.
CECL (Current Expected Credit Loss) has created very large write downs and if you look at CU financials you will see big losses at CU’s that have only 1% of loans in 60+ days delinquent category.
Wait I thought the market anxiety was a result of shenanigans coming out of the Capitol?
If you Prefer–Who knows for 100%–but one always needs to read, observe and make their decisions based on a weighing of all opinions.
Yeah true but sometimes you have to question the statements posed as questions. …. “Like what is the correct ignition timing on a 1955 Chevrolet Bel Air with a 327-cubic-inch engine and a four-barrel carburetor”
I saw a research report that said “Are you underweight bitcoin?”……….But get it? It’s a loaded question. They aren’t allowed to buy bitcoin. Only unsolicited transactions. And you cant unsolicited for your own account. So there is no weighting in bitcoin yet the question implies that there is!!!
We have lived thru 87, Gulf War, 94 com, Mexico default, dot com, 08, you name it we’ve seen it.
Loved that movie…. Yutes? What’s a yute?
If You Prefer…… Timing should be around 8 degrees before Top Dead Center at idle with the vacuum advance plugged ( golf tee works great). At 3000 RPM should be around 36 degrees or so. The 327 came in several varieties and these numbers vary a little too. By the way the 327 was introduced in the early 60s, so your 1955 got a very nice transplant. I wanted one in my 1959 Chevy Club Coupe, but settled for the 307 as it fit my budget. Now, I’m definitely underweight in crypto as I don’t have any!
Dj, maybe you already know this, but that quote is from “My Cousin Vinny” (and your comment about when the 327 was introduced is exactly the point).
https://www.americanrhetoric.com/MovieSpeeches/moviespeechmycousinvinny4.html
If you Prefer–yep in our years we have seen a lot of stuff–not much happens anymore,anywhere that is a huge surprise to me.
Agreed. We do have very narrow credit spreads, which is either an indication
investors believe risk is limited in the foreseeable future or there is with the much money chasing too few structured products !
It’s too bad I missed the conference as it was going on right under my nose in Vegas. In the past if I wanted to attend a Vegas conference I’d print up biz cards. I have some new suits I had made in Vietnam a few years back and I’d like to have found out if they still fit while seeing who I can snow.
Do we have any structured product that provides exposure to tranches of other structured products which provide exposure to tranches of another structured product? Probably , but I’d rather not think about it. My head is hurting and every time the market dips I hget worried about anything not AA+ or above…or FDIC insured.