CLOs, Private Equity, Pensions, and Systemic Risk

Abstract

There has been much recent discussion of the increasing risk of Collateralized Loan Obligations (CLOs) and their feeder collateral, leveraged loans (LLs). The models ratings agencies use rely on similarly flawed methods in place since the mid-2000s and the nature of the collateral coupled with dramatic recent increases in risk of the underlying loans and conflicts of interest suggest that CLO ratings should be capped at a level far below AAA. Just as in 2008, the market is engaging in a collective grand illusion without adequate scrutiny of the actual risk and meaning of a AAA rating.

The risk goes far beyond CLOs and permeates the larger economy. There is frothiness and irrational exuberance permeating an “Iron Triangle” of private equity firms, CLOs, and pension funds. Systemic risk may be realized through significant job losses, rising pension fund deficits, credit losses for funds, insurance companies, and banks, and significant disruption to critical industries. The risk could be on the scale of the global financial crisis (GFC).

The main systemic risks include 1) Employment: Private equity-owned companies employ nearly 9 million people; 2) Pension funds: Face potential losses on existing investments and perhaps more importantly may need to revise lower future return assumptions—these factors put millions of pensions at risk; 3) Investment losses: Banks, insurance companies, and funds are exposed to CLO and/or leveraged loans and face significant potential losses; and 4) Critical industry fallout: Many industries controlled by PE companies face widespread disruption should the funding vehicles of CLOs and leveraged loans freeze up.

TOPICS: CLOs, CDOs, and other structured credit; financial crises and financial market history

Key Findings

• • This article argues that Collateralized Loan Obligations (CLOs) do not justify AAA ratings and that there is significant systemic risk emanating from the “Iron Triangle” of CLOs, private equity (PE), and pension funds.

• • The AAA rating should be challenged across two broad fronts: the rating agency approach and the substantial increase in risk in the underlying leveraged loans in recent years.

• • Systemic risk: The Iron Triangle between CLOs, PE, and Pensions create significant systemic risk potentially on the scale of the Global Financial Crisis (GFC).