
Wall Street’s Latest Love Affair with Risky Repackaged Debt - cow9
https://www.nytimes.com/2019/03/18/opinion/wall-street-risk-debt.html
======
RubberbandSoul
I have this growing conviction that some of the people working in financial
markets are something akin to black hat hackers. They continuously probe the
system for bugs and weaknesses and then exploit them for profit. This
"collateralization with obfuscation" exploit where it's impossible to
calculate the risks of bundled investment packages should have been "patched"
with legislation after the 2008 crash but wasn't. So, unsurprisingly, they go
after it again.

~~~
bko
Remember the Gall-Mann amnesia effect: expert believing news articles on
topics outside of their field of expertise even after acknowledging that
articles written in the same publication that are within the expert's field of
expertise are error-ridden and full of misunderstanding

While the article mentions the 2008 financial crisis, it does not mention that
CLOs existed prior to the crisis and performed well during that time, much
better than other securitized products.

> The CLO asset class has performed strongly, according to a recent report
> from S&P (“Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance
> From 1994 Through 2013”), with few negative rating actions on senior notes
> due to underlying collateral deterioration, few defaults, and minimal loss
> rates since the agency started rating the asset class in the mid-1990s...
> Looking at the default statistics, of the over 6,100 ratings issued by S&P
> on over 1,100 U.S. CLO transactions, only 25 tranches have defaulted and had
> their rating lowered to D as a result. Based on this, S&P calculated a 0.41%
> default rate, or just over four tranches for every 1,000 it has rated.

The reason is that the collateral is higher in the capital structure than debt
so defaults are much less likely and recoveries in case of default are higher.

I don't like how pop-financial articles talk about risk and debt. Companies
aren't "risky" like a crappy car is risky. It's not that they cut corners and
put lives at risk. Leverage and debt are normally conscious decisions made by
the company. There is some optimal debt level that they strive for. The higher
the debt, the higher the cost, but the greater return you can make. So like
anything it's a trade off. I also resent the fact that any company with a non-
investment grade debt rating is written off as unworthy of credit.

[0] [http://www.leveragedloan.com/sp-report-clos-show-strong-
hist...](http://www.leveragedloan.com/sp-report-clos-show-strong-historic-
performance-with-few-defaults/)

~~~
dragontamer
> Remember the Gall-Mann amnesia effect: expert believing news articles on
> topics outside of their field of expertise even after acknowledging that
> articles written in the same publication that are within the expert's field
> of expertise are error-ridden and full of misunderstanding

This trope is tired and very annoying each time I see it come up.

I'm an expert in Programming Computers (at least, that's my job, so I assume
I'm an expert). So I laugh at WashPo or New York Times, or Bloomberg whenever
they make simple computer-related errors in their article.

But guess what? I'm not paying Wash Po for my computer news. I'm paying ACM or
IEEE actually for computer news. But ACM / IEEE have no news on financial
markets. (Bloomberg is an expert newspaper in the realm of finance).

ACM / IEEE don't have many articles on politics. Washington Post is far better
at describing the daily political issues in the capital.

Al Jazeera gets American news incredibly wrong sometimes. But I'll trust Al
Jazeera on middle-eastern news over almost any American-based paper (aside
from Wash. Po, which has a solid foreign politics / world politics section).

Throw in a few "Conservative" newspapers for the conservative slant on issues,
and you can get a decent balance of news from a variety of sources.

I don't expect general Newspapers to be an expert in my field. I read
newspapers to learn about things OUTSIDE of my realm of expertise. Believe it
or not, newspapers have "specialties", and they're quite good if you read them
based on what they're actually an expert in.

\-------

Honestly, I don't read too much NY Times, so I dunno what they're an expert
in. Financial news is definitely a Bloomberg thing IMO.

~~~
pmart123
Bloomberg, FT, institutional investor, CFA, abnormalreturns.com does a decent
job of aggregating. Sometimes Barron’s is ok. Blogs and podcasts can be
better. It’s always good in finance to think “does this guy have an agenda or
bias to push?” when a famous investor is being interviewed.

~~~
dragontamer
Individual blogs are good if you know the individual author and trust them
well. Basically, a blog is great to follow a specific person you trust.

But individuals still only have expertise in a narrow field. I'm not going to
be reading Herb Sutter's blog for Java-programming news, or "The Old New
Thing" (Windows-blog) for even Linux-ARM news. I read Herb Sutter for C++, Old
New Thing for Windows-specific stuff.

To get more information from a wider variety of sources, you end up reading
Newspapers. You learn to trust the editor, a non-expert but someone who tries
to promise quality of their writers follows a certain code. Even within a
newspaper, different editors handle different sections (the OpEd section of
WashPo is less factual than other sections)

As long as you understand the trust model of various sites or newspapers,
things are good. Some amateurs on "Seeking Alpha" or "Medium" are pretty darn
good with their analysis, you just gotta learn their names and follow them
specifically.

~~~
pmart123
That’s a good point. Without expertise, it’s much harder to filter good
independent sources versus crap.

------
piokoch
Reading this made me speechless. One thing is that the same story repeats
again (I am only curious if someone is playing against CLO now as "The Big
Short" guys did.)

But this...

"They buy a little of the debt of risky companies at a discount, and then buy
a much larger amount of insurance on that debt [...]. These wiseguys then do
everything they can to force the company into a bankruptcy filing. [...] Since
the insurance payment exceeds by far the overall cost of the discounted debt,
the hedge fund profits handsomely."

Isn't this insurance fraud? It looks for me like this: I am buying a crappy
car, I am somehow able to insure it for a large amount of money (exceeding car
value), then I am putting this car on fire and grab insurer money.

~~~
lucozade
> I am only curious if someone is playing against CLO now as "The Big Short"
> guys did

Absolutely they are. The heroes of The Big Short weren't doing anything
particularly unusual or special. They were just using credit instruments to
bet that they'd be more foreclosures than the market was predicting. There'll
be equivalent hedgies doing the same with corporate debt now.

> Isn't this insurance fraud?

No because it's not actually insurance as others have said. They're using
similar credit instruments to bet against corporates that the Big Short folk
used to bet against mortgages.

Is what they're doing ethical? Probably not though you have to be careful. If
you look at the Windstream example linked in the article, I'd argue that the
hedgie is using ethically questionable methods to expose, and take advantage
of, ethically questionable corporate practice. Not entirely clear who the
villain is with that one. Probably both parties.

~~~
longerthoughts
The article treats the Windstream example like a smoking gun for market
manipulation but the cited evidence is a little softer than he's suggesting.
All the link really provides is Windstream's claim that Aurelius forced them
into bankruptcy, which the judge evidently didn't find to be compelling.
Windstream proposed a recovery plan for any default caused by the Uniti
spinoff and Aurelius didn't agree to the plan. That doesn't prove that
Aurelius shoved Windstream in front of a train, only that they didn't pull
them off the tracks.

------
lefstathiou
CLOs are comprised of loans made to small businesses. Small businesses are
inherently risky. CLOs exist because they are a relatively inexpensive form of
long term funding. Let’s ponder the type of people who start and operate small
businesses and whether or not they get access to competitive bank financing...

Once upon a time, seeing entities willing to write loans to small business was
worth celebrating. Amusing that once we find out it’s Wall Street stepping in
to facilitate this at a scale the government cannot, it is dangerous gambling.

~~~
marcosdumay
There is absolutely no problem in making risky loans. But there are many
problems with packaging those loans together and selling them to a third party
that can't calculate its risk level claiming it's low risk.

~~~
lefstathiou
An important clarification here: CLOs are sold to multi billion dollar asset
managers (technically referred to as QIBs, entities that manage at least
$100mm in Assets Under Management or more - the vast majority of the
structured products business is dominated by large fund managers).

It is the highest tier of investor "suitability" recognized by the SEC. It's
their job to understand these products and they have armies of people for it.
It can take weeks to "market" these transactions and plenty of opportunities
to sit down with bankers and CLO managers to get smart on the space. There is
also a ton of supporting technology and research, all of which is available
for free on S&P, Moody's, Fitch, Kroll and Morninstar's websites.

If you cannot sell this stuff to a QIB, who can you sell it to?

------
isoskeles
> Those investors include Japanese banks as well as investors in hedge funds,
> mutual funds and pension funds (in other words, you and me).

I laughed. You and me, NYT reader who is rich enough to have a 401k.

> The existential question remains: Why do investors fail to learn the harsh
> lessons about risk, even though the consequences of them still remain so
> fresh?

I hate to be that guy, but at what point can I blame the Fed for near-zero
interest rates that have motivated traders to seek higher gains? I appreciate
that people are being more vigilant about reporting on this, but I’m starting
to think blaming it on the traders is the easy way out. It seems especially
easy when we can draw obvious comparisons to 2007-8 (CDO => CLO, that’s just
one letter changed it must be the same thing!). And it sounds like even if
these traders weren’t trying to force overleveraged companies into bankruptcy,
those companies must be in a precarious enough position that it could happen
on its own. Am I mistaken?

~~~
pjc50
The near-zero interest rates aren't low enough. Small negative rates are
probably required to suck some money out of the speculative economy.

> motivated traders to seek higher gains

A trader who doesn't seek higher gains is a shark that stops swimming and
dies. There's no need to blame interest rates for this.

~~~
rpz
Negative rates won't send traders out of business. There are still plenty of
trades to make in a negative rate environment. In any case, I'd be interested
to hear your argument on why small negative rates are good for the economy in
general.

~~~
Nasrudith
Not the poster but the theory is that it discourages deflationary behavior of
funds sitting around and keeping demand down.

Personally I suspect that it is overly risk boosting and encourages
economically perverse behavior but it apparently hasn't proven disastrous yet
in the locales that have tried it.

------
ikeboy
The article is conflating two distinct issues - CDS warping incentives, and
CLOs.

CDS is primarily relevant to bonds that trade on the open market. CLOs are
packaging private loans made by banks, not bonds. To treat them as relevant to
each other demonstrates the author has no clue what they are talking about.

~~~
mlevental
>By William D. Cohan

[https://williamcohan.com/about/](https://williamcohan.com/about/)

who shall i believe? you or him?

~~~
ikeboy
Don't know what to say then. Maybe the editor insisted this crap be included?

------
oli5679
Does anyone understand the logic of this statement? I can't make heads of
tails of it, which lowers my trust in the article overall. If people are
arbitraging derivatives priced differently to underlying asset then that seems
pretty benign to me? Is there something else going on here?

One backdoor risk is exacerbated by a tactic of some all-too-clever hedge fund
managers. They buy a little of the debt of risky companies at a discount, and
then buy a much larger amount of insurance on that debt — so-called “credit
default swaps” — to theoretically hedge their risk. These wiseguys then do
everything they can to force the company into a bankruptcy filing, which
contractually triggers the insurance payoff on the debt. Since the insurance
payment exceeds by far the overall cost of the discounted debt, the hedge fund
profits handsomely.

~~~
haroldl
I think the analogy is to suppose you insure your car with 10 different
policies and then total it so you can collect 10x what it is worth.

------
redwood
What's the relative size of this market, particularly the high-risk segment in
comparison to the size of the subprime mortgage segment and associated CDOs in
the 2008 crisis?

Without a sense for whether the order of magnitude is similar, it's hard to
draw conclusions on the level of systematic risk.

~~~
ddoolin
The article says that leveraged corporate loans make up about $1.2T. Wikipedia
says the subprime mortgage market was around $1.3T in March 2007.

[https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subpr...](https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#Subprime_mortgage_market)

~~~
redwood
Wow thanks. That certainly makes things more acute!

I suppose businesses are structurally different from home buyers in a number
of ways: for example when a business goes bankrupt (correct me if I'm wrong)
creditors are paid out to the extent they can be. Whereas when a home owner
goes bankrupt I believe they can get out of their obligations entirely.

------
qpotlpus
CLOs are not inherently good or bad. The difference is in how they are
structured and priced. On the benefit side, CLOs have effectively permanent
financing in place which takes the liquidity run risk off the table (and thus
is more systemically stable) than loans funded with bank deposits.

------
zelon88
Here's a heartwarming tale of a man who got a call from a debt collector with
a fake note threatening to rape his wife. It started his years-long crusade to
bring down the loan sharks responsible for selling fake debt with his name on
it.....
[https://www.bloomberg.com/news/features/2017-12-06/millions-...](https://www.bloomberg.com/news/features/2017-12-06/millions-
are-hounded-for-debt-they-don-t-owe-one-victim-fought-back-with-a-vengeance)

------
m101
There are a number of errors in this article, and there are important things
that articles like this fail to mention:

\- the loans aren't made by the banks and then shifted, they are more often
sold to investors without the bank assuming any of the loan themselves (it's
called loan syndication). The bank simply acts as the role of arranger.

\- the Japanese investor base is mostly in the most senior part of the capital
structure

\- for similar credit ratings CLOs have far lower default rates than for
equivalent corporates. It's something like 2-3% in the B and BB rated tranches
through the crisis

\- the average piece of CLO equity returned something like mid-single % digit
returns if held through the whole of the financial crisis

\- the paragraph on credit default swaps is a distraction. No CLOs use credit
default swaps, and certainly no one sells credit default swaps which reference
CLO tranches. This happened prior to the financial crisis through synthetic-
CLOs but these don't exist anymore. Sometimes investors in CLOs use credit
default swaps against an index of credits (like XOVER for instance), but this
doesn't really work as a CLO hedge

The facts are that many lessons have been learned since the crisis and people
aren't doing the same things they did back then.

What can be said is that there is a race to the bottom in terms of loan
covenants diminishing, but this is driven by larger demand for loans than
supply resulting in borrowers achieving looser document terms. The drivers of
this are often the law firms that work on behalf of the borrowers who promise
being able to achieve looser and looser language with a view to winning the
business. Unfortunately the lenders have a weak hand in this situation as they
are many chasing few assets and find it difficult as individual institutions
against a syndicating bank and borrower who have full information and can play
lenders off against each other.

------
4RealFreedom
A lot of good comments. I just wanted to point out that the last line in this
article states 'Why do investors fail to learn the harsh lessons about risk,
even though the consequences of them still remain so fresh?' Speaking about
the past market problems, if no one is held accountable why should change
occur?

~~~
michaelmrose
At the top where it matters they don't experience as many negative
consequences long term as middle class and down.

If they lose half their wealth they don't buy a new boat this year.

------
ssrcity
A major issue in 2008 were loans made with no credit standards and investors
were being sold what they thought was AAA credit risk when in reality the
borrowers behind the securities were people with little income make the
mortgage payments they were obligated to. The article at hand does little to
prove that a similar phenomenon is going on with corporate bonds. Would be
interesting to know whether the corporates spoken about here are public or
private companies since, if they are public, any going concern can easily be
analyzed via a company’s SEC filings.

There’s no doubt that the structure of this product is similar to products
which caused the financial collapse, but are all the other systemic issues
present? I don’t think the author addresses that.

------
manyhats
1\. It's important to distinguish between liquidity risk and solvency risk.
Liquidity risk is needing to sell an asset that is fundamentally sound and not
being able to get a fair price, or any price at all (as happened in 2008/2009
- no/few buyers and many sellers). Solvency risk is the asset goes bad and
there's a permanent impairment.

Simplistically:

liquidity risk = broken leg (painful and needs immediate treatment, but
recovery over time likely)

solvency risk = horrible cancer

2\. CLOs are made up of bank loans, which are generally the most senior
obligation of a company, and are the least risky. Bonds, preferred equity and
common equity get hit before the loans are impaired. During the period from
1998 through 2016, defaulting loans recovered 66% of their value while bonds
recovered 40%. [0]

3\. CLOs generally made it through 2008/2009 without any major issues. The
structures held up as designed, but prices fell along with other structured
products since there were few buyers and many sellers.

If you were able to hold, you did reasonably well. Over the 20 year period
from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted
(no AAA or AA defaults) and had a 0.04% loss rate. [1]

4\. What has changed since 2008 is that loans are becoming a larger portion of
the total value of the business (loan-to-value). This means that if the
business goes bad, there's less of a cushion for the loan and recovery rates
will be lower.

I don't know how much lower, but some of the junior tranches in a CLO could be
impaired in a severe downturn. It's hard to really know, but I _think_ things
would need to be worse than 2008 (or the same level of crisis, for a longer
period) for AAA tranches in general to be permanently impaired.

5\. Accounting plays a role here. If you are required to mark-to-market, then
the market clearing price is what the asset is worth, regardless of
fundamentals. If there's a panic, you may be a forced seller if you don't have
sufficient reserves to get through the disruption and your mark-to-market loss
becomes a permanent loss. This applies to any asset class, not just structured
products.

6\. I don't understand why the article brings up CDS gaming. It's a real
issue, and one that is being worked on, but it's not even a rounding error
compared to the size of the corporate debt universe. [2]

quote from the FT article:

"Isda’s method of “fixing” CDS has always been akin to “patching” software
after hackers exposed weak points. When one window closes, traders simply find
a new one."

[0] "JPMorgan Default Monitor 4Q16"

[1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From
1994 Through 2013”

[2]
[https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32a...](https://www.ft.com/content/efab718a-40c9-11e9-b896-fe36ec32aece)

~~~
o_nate
These are good points. I would add that generally there's not a problem with
having lots of risky debt in the system, as long as it's held by investors who
are aware of and can handle the risk. The reason that CDOs led to the
financial crisis, was that there was lots of risky debt being packaged as AAA
and held by investors (i.e. systemically important banks and insurance
companies) who couldn't handle losses on it. So the big questions about CLOs
should be: who's buying the AAA debt, is it being mis-rated, and if so, can
the holders handle losses on it. In general, I think the rating companies
reacted to their vast and obvious failings in 2008 by tightening rating
criteria across the board, even in structures such as CLOs which did okay
during the crisis. Is it possible they're still being too optimistic? The
thing about the rating models is that they're very sensitive to correlation
assumptions that are difficult to observe empirically. Also, they tend to have
a blind spot about things like fraud. Is it possible that junk-rated corporate
defaults could end up being much more highly correlated than the models
assume? There are transmission mechanisms that can cause high correlation. For
example, an uptick in defaults in one sector could lead to a tightening of
credit standards across the board that could lead to rollover risk. (Most of
these companies are highly dependent on being able to rollover maturing debt.)
Or fraud in underwriting standards could be much more pervasive than assumed.
(This one seems unlikely, but who knows.)

------
aetherspawn
ELI5 would be appreciated here for those of us who aren’t stock investors to
understand this.

~~~
grey-area
The 2018 crisis was caused by CDOs - packaged mortgage debt which is going to
default, mixed and dressed up as very safe debt, then sold on to some poor
sucker (including you in your pension).

[https://www.youtube.com/watch?v=xbiDrzTd8fE](https://www.youtube.com/watch?v=xbiDrzTd8fE)

The article is saying that people are buying CLOs - packaged corporate debt
which is going to default, mixed and dressed up as very safe debt, then sold
on to some poor sucker (including you in your pension).

TLDR: History repeats itself, first as tragedy, then as farce.

------
asabjorn
If you put this is context of long-term economic stagnation where the kind of
predictable growth modernity brought over two hundred years is no longer
there, then for people that are expected to generate large returns have a
large incentive to take on riskier investments that might give an growth
upside.

Eric Weinstein argues [1] that what we are experiencing is a long-term
stagnation of western economy, and arguably any economy that is not catching
up. This is in his estimation the cause of many of our issues.

[1]
[https://www.youtube.com/watch?v=TKeMIWVOnbo](https://www.youtube.com/watch?v=TKeMIWVOnbo)

------
nimbius
I see a lot of comments in the article on how this is just a scare piece, but
it bears remembering just how big of a crisis the 2008 financial collapse was.

Stagnant wages in the 90s gave rise to credit cards and personal debt-as-a-
feature capitalism, which was immediately blown out of the water by 2008.
people lost their homes because the credit system keeping them afloat
basically collapsed. businesses started shedding employees and shuttering
doors, while banks across the world began a series of spectacular failures.

Not just banks and auto makers, but capitalism itself looked to be slowly
collapsing under its own weight of the hubris of mankind. Its really stunning
to look back at some of the absolutely bombastic thing we said and did in the
service of not people who were displaced and destitute after this collapse,
but in the service of trying to keep capitalism going for ten more years. At
some point we started bribing people to participate in the market that just
made them homeless with "cash for clunkers." This was an asinine program
designed to "boost the economy" by paying people to destroy their already
running vehicles under the guise that they caused too much pollution.

This didnt work. It could never work, and so we switched tactics toward simply
bailing banks and auto manufacturers by cutting trillion dollar checks and
printing more cash. Nobody who caused the financial collapse was ever
arrested, save perhaps Bernie Madoff for his high treason of swindling the
plutocracy. At the last few months of the term of George W Bush, a round of
"stimulus checks" were cut and sent back to americans. The idea here was that
americans would buy new televisions and sneakers. The reality for many,
including me, was that money went to savings or closing out credit card
accounts we didnt need.

And here we are, once again, at the brink of another 10 year cycle. Things
seem fine but theres hand-wringing from the usual suspects about systems of
credit and debt so complex they cannot possibly exist outside a PhD thesis.

------
jimmy_ruska
Why would they fix the problem. Every crash is a redistribution of wealth.

When there's a recession, if you're wealthy and have diversified assets you
can buy everything at a discount rate during a stock crash and sell when the
recession recovers. Meanwhile, the poor and middle class often find themselves
unemployed, their savings accounts massively depleted and in a constant crush
for cash.

If you're wealthy AND you have the ability to create risk in the market, then
even better. You can actually help trigger more "stock discounting" events,
and dominate any emerging technology company with your bootstrapped companies
while everyone is dying for credit.

~~~
jmh530
The wealthy disproportionately have their money invested in equities. The
ultra wealthy are also typically highly concentrated in specific companies,
think Jeff Bezos and Amazon. They tend to lose more when the market crashes.

~~~
gryfft
Yes, they lose more. They lose _proportionally_ less. They're not winding up
on the streets. It's disingenuous to pretend that it has anywhere near the
impact on their lives as it does the other 99.9% of the participants in the
economy.

~~~
almost_usual
They definitely can end up in the streets. Some of the wealthiest people
suffered the most during past crashes, most killed themselves before taking
the streets. Read Devil Take the Hindmost.

Edit: I’m not going to search through this book to find sources that fit some
criteria you’re looking for. Get off HN comments, read a book, and learn some
financial history lessons.

~~~
gryfft
I haven't read it, but I have a feeling we're not talking about the same
people. I'm not talking about successful investors and millionaires. I'm
talking specifically about net worth north of $200M in today's dollars. Not
the people who jumped from their windows during the Depression. The ones who
bought their stock and waited it out.

Edit: I've now read a few reviews and summaries of _Devil Take The Hindmost._
Its subtitle is "A History Of Financial Speculation," and it appears that its
subject matter is not focused on ultra-wealthy persons with diversified
portfolios being ruined by market corrections, but specifically speculators
and frauds. At a glance, it doesn't look particularly relevant to this
conversation.

~~~
almost_usual
Some of the _wealthiest_ people in modern history have lost it all. A recent
example is Eike Batista.

~~~
gryfft
Batista is currently under arrest and has been sentenced to 30 years in prison
for bribing disgraced Rio de Janeiro governor Sérgio Cabral, in order to
secure public contracts, according to Wikipedia[0].

I'd prefer an example that isn't somebody who wound up in prison.

0\.
[https://en.wikipedia.org/wiki/Eike_Batista](https://en.wikipedia.org/wiki/Eike_Batista)

~~~
almost_usual
Read the book then because I’m not going to search through it to cite a rich
person who lost it all that fits your changing criteria.

~~~
michaelmrose
Citing an entire book as a source is quite frankly a ridiculous suggestion.
You are suggesting that the poster should spend hours proving your position
for you when you wont spend a few minutes.

------
bitxbit
Wall Street’s Love Affair with Financial Alchemy. Modern finance, particularly
how we define risk (and volatility), is deeply flawed.

------
pepy
paywall help anyone?

~~~
peteretep
If you look on the comments page, under the title is a link that says "Web"
click on it, and then follow the first link.

~~~
pepy
guess we dont have the same first link, waiting for someone to archieve.is- it

~~~
michaelmrose
[http://archive.is/dKiAg](http://archive.is/dKiAg)

