The C.L.O., a cousin of the mortgage-related product that malfunctioned a decade ago, has become one of the hottest investments on Wall Street.
A financial assembly line that went haywire a decade ago and contributed to an economic crisis is gearing up again on Wall Street.
Back then, one of the products the banks churned out — bondlike investments based on thousands of mortgages — proved far riskier than most banks, investors and regulators had expected when many borrowers couldn’t pay. The banking system froze, a financial panic ensued, and the country experienced its worst recession in decades.
This time around, a similar kind of investment, called C.L.O.s, are at the heart of the boom. And that’s not the only parallel: The loans are being made to risky borrowers, lending standards are dropping fast, and regulators are easing the rules.
While it isn’t necessarily destined to end in a 2008-style collapse, the situation today is eerily familiar. Even top Federal Reserve policymakers cited the surging growth of this market as a reason to “remain mindful of vulnerabilities” and possible risks to the financial system.
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“If there turns out to be an issue, this is where the unfinished business of the post-crisis financial reform efforts is going to be revealed,” said Daniel K. Tarullo, a professor at Harvard Law School and a former oversight governor for bank regulation at the Fed.
Here’s what you should know about one of the busiest lines of business on Wall Street.
A different set of risky borrowers, and slipping standards
The process of issuing loans, packaging them together and carving them into investments has many names: securitization, structured finance, even shadow banking.
The last shadow-banking frenzy on Wall Street centered on home loans, which were repackaged into investments used to build collateralized debt obligations, or C.D.O.s.
Banks pooled millions of mortgages — some of them to borrowers with a shaky ability to repay — to create C.D.O.s. They kept some, and the rest they sold off to a slew of other investors: in-house hedge funds, European banks, large American pension plans and more.
The investments at play now are C.L.O.s, for collateralized loan obligations. But this time, the underlying loans aren’t going to high-risk homeowners. They’re going to high-risk companies.
These C.L.O.s are made up of loans to between 100 and 300 already indebted corporate borrowers. Sears, which filed for bankruptcy this week, was among the companies that took what are called leveraged loans.
Such loans to companies with junk-level credit ratings hit a record of more than $550 billion last year, eclipsing levels in the last years before the financial panic.
Most of the borrowers with junk-level credit ratings are already carrying a debt load. (Other low-rated borrowers might just be small or new.) But demand for C.L.O.s has been so strong that investors aren’t placing as many requirements on the loans being made to these risky borrowers.
Traditionally, such loan contracts would have all sorts of protections, known as covenants, aimed at providing investors an early warning that borrowers were getting in trouble.
These covenants keep debtor companies from acting in ways that put payments to investors at risk. They restrict things like paying out dividends to owners, and put limits on additional borrowing.
Nowadays, the vast majority of leveraged loans contain much weaker protections. So-called covenant lite loans now account for roughly 80 percent of the new leveraged loans on the market.
And when loans are repackaged and sold, most of the money effectively comes from the investors, not the banks.
And there’s a tendency to be less careful when lending other people’s money. This incentive problem was at the heart of the lending that led to the last financial crisis.
To fix that problem, the Dodd-Frank financial regulation law required the loan packagers to retain some of the risks of the investments they created.
But those rules have been weakened this year. A court decision exempted some of the firms that create C.L.O.s from a requirement that they hold at least 5 percent of the credit risk in such investments. The Federal Reserve and the Securities and Exchange Commission declined to appeal the decision.
Right now, leveraged loans are some of the easiest products for financial firms to sell. Unlike most bond investments, which have fixed interest rates, leveraged loans typically have floating interest rates.
Floating-rate products do better than most bonds when interest rates rise, and those rates have been climbing. As long as rates continue to push higher, there will be a demand for leveraged loans.
But not everybody is thrilled with the idea of lending to already indebted companies, so financial engineers have transformed these loans into something more attractive.
The assembly line gets rolling again
C.L.O.s, which have been around since the mid-1990s, are a type of asset-backed security, which is, essentially, a kind of bond. But unlike a regular bond, in which a single company repays interest and principal to bondholders, they combine multiple repayment streams — thousands of monthly credit card, auto loan or mortgage payments, for example — and funnel them to investors.
Broadly speaking, here’s how it works. A C.L.O. manager buys a diverse bunch of leveraged loans and simultaneously lines up investors who are willing to buy a piece of this package. Each quarter, the indebted companies make payments on those loans, and that money is channeled to the end investors.
But C.L.O. investors aren’t all the same. They get to pick what is more important to them: low-risk returns or big payday potential.
Pitting a piece of the pie against patience
Let’s imagine that the proceeds from C.L.O.s are a pizza that arrives each quarter.
When it arrives, the investors have to form a line to see who eats first. That’s determined by the amount of risk they agreed to take on when they put in their money.
Those who are first in line take only a small amount of pizza: Low risk, low reward.
The investors at the end of the line take what’s left when everyone else has eaten. This is risky: If only a small pie comes to the door, there’s a chance that there won’t be any when it’s their turn.
The party is still going strong
Right now, there is more than enough pizza for everybody at the party.
The American economy is strong. Gross domestic product grew at a 4.2 percent annual rate in the second quarter. Unemployment is near 50-year lows. Corporate earnings are high.
That means most of the companies that took out these loans are having no trouble with their payments. In fact, defaults on leveraged loans are quite low.
The good times can’t last forever, but that doesn’t mean C.L.O.s will bring down the economy.
The size of the C.L.O. market is only about one-tenth the size of the American mortgage market during the years before the crisis a decade ago.
But it’s not exactly small, either. The market for leveraged loans is larger than the market for junk bonds. And blowups in the junk bond market — most notably in the late 1980s — have caused problems before.
And while people in the C.L.O. business point out that these assets fared pretty well during the last recession, nobody knows how the investments will perform when the next downturn comes.
All of that makes the C.L.O. business a prime example of the type of finance that has fueled bubbles, booms and busts in recent years.
“Maybe this would be just a bad recession when this collapses, not the Great Depression,” said Simon Johnson, a professor at the Massachusetts Institute of Technology and a senior fellow at the Peterson Institute for International Economics.
“It wouldn’t be as bad,” he added. “But it could still be bad.”