The hidden “CLO” problem in financial markets, according to former investment banker Raoul Pal.
Illustration by kierstenessenpreis.com
The health crisis seems to be the common reason people are arguing over whether the stock market will go up or down.
There’s a hidden problem in financial markets that many people can’t see and don’t understand.
I am going to give you a simplistic overview after working in finance for so many years and being determined to make the complex, understandable.
The 2008 financial crisis was caused by CDOs (Collateralized Debt Obligations). Investopedia describes this complex financial product nicely:
A CDO is a box into which monthly payments are made from multiple [home] mortgages. It is usually divided into three tranches, each representing different risk levels.
When the homeowners had issues repaying their mortgages, the CDO product, along with mortgage-backed securities, blew up and caused The Great Recession of 2008. The issue was that the home mortgages were examined by ratings agencies who gave them a rating. They were also incentified to fudge those ratings for a fee.
Investors thought they were investing in mostly AAA quality mortgages when they were in fact investing in toxic loans that were taken out by people who should of never been given them because they didn’t have enough money to pay back the loan.
In 2020, another very similar financial product known as CLOs is making investors nervous, according to Law Professor Frank Partnoy.
Unlike CDOs that are associated with home mortgages, CLOs are tied to business debt. When businesses can’t pay back their debt, the same scenario as 2008 can essentially play out. (In the current environment, do you think businesses would have any issues paying back debt? How about hospitality or travel?) It all comes down, again, to whether the rating agencies rated the quality of the businesses taking on the debt effectively.
What you have to consider is whether the ratings agencies are being properly regulated this time. In 2008, human greed was stronger than regulation.
Will human greed be stronger than regulation this time around?
The challenge with CLOs is you can’t look up how many of them exist. The estimated total value of CLOs is over one trillion dollars, says The Wall Street Journal. CDOs and CLOs are part of the derivative family of financial investments and the challenge with them is they are incredibly complex.
Their complexity makes them risky not only for the investors, but for the financial system and the stock market many of us invest in both voluntarily, and involuntarily through our retirement accounts.
Insiders in the finance world are already leaking information that suggests, perhaps, the same issue as 2008 is about to transpire again. Popular Twitter personality and ex-investment banker Raoul Pal is all over the CLO problem too. The issue this time is we have a global health crisis to contend with, as well as a potential financial crisis due to the risk of CLOs.
Just as easy mortgages fueled economic growth in the 2000s, cheap corporate debt has done so in the past decade, and many companies have binged on it — Frank Partnoy
The challenge is that last time the government stepped in and threw cash at the problem. The idea investors have to contend with is whether the government will take the same action again.
Betting the government will save you is a risky assumption.
Even if you haven’t invested in CLOs, it’s all of our problem. The financial institutions that have invested in CLOs are public companies that are listed on the stock exchange. Those same institutions hold your savings, retirement money, and any stocks you have purchased. This means if they have a problem, then we all have a problem.
Every financial product is tied to each other — if one fails, it can affect another. The similarities between now and the 2008 Stock Market Collapse are uncanny. It feels like a repeat, plus the addition of the health crisis.
What Can You Do About This Problem?
I look at the billionaires. Warren Buffet is sitting on huge piles of cash.
George Soros has sold all of his banking stocks recently. These famous billionaire investors clearly know something that not everybody has come to terms with. The current environment is full of risk.
Too much risk makes you stressed.
When nobody knows what is going to happen because it has been so long since we’ve dealt with a health crisis like this before, cash can make you feel like a king or queen. At the very least, it’s worth furthering your financial education. Learn about the Spanish Flu of 1918 and its effects on the stock market. Delve into the 2000 Tech Bubble and the 2008 Financial Crisis to gain an understanding of what we might be facing.
The worst thing you can do is believe the hype, take what traditional media says is the truth, and continue to place money into the stock market when you don’t understand what is going on.
The stock market is fine until it’s not fine — that’s when financial literacy takes money from those who know nothing and places that money into the hands of those who know the game inside and out, or spent the time to learn it.