Since 1975
  • facebook
  • twitter

The risk to post-pandemic recovery from growing corporate debt

Short Url:
30 May 2020 03:05:25 GMT9
30 May 2020 03:05:25 GMT9

It seems counter-cyclical to point out, as countries around the world are beginning to emerge from the coma of lockdown, that we are far from the end of the fall-out from the coronavirus pandemic.

Still to come in the horror year of 2020 is a list of potentially damaging economic factors such as the destruction of GDP growth for the rest of the current year, a sharp decline in corporate earnings for at least the first three quarters, and a deterioration in the financial health of corporations and individuals as business activity struggles to adapt to the new normal of post-pandemic life.

Now, to add to this list of worries, some financial analysts have identified what they regard as the weakest link on the global financial system which, if it breaks, could add a financial crisis to the economic downturn we are suffering.

Collateralized loan obligations (CLOs) could be the instruments that spark a collapse in financial markets, compounding the economic problems still to come in 2020.

CLOs are pretty similar to the collateralized debt obligations (CDOs) that sparked the global financial crisis. They are groups of assets of variable quality bundled together as a tradable instrument which is bought and sold on the global debt markets by institutional investors.

In the early 2000s, CDOs consisted mainly of mortgages, varying from triple-A-rated real estate to the “trailer trash” properties euphemistically described as “sub-prime.” When the US property market turned negative, sub-prime went first, infecting even the good-quality assets in the CDO.

The result was the toxic debts of banks and financial institutions that had to be bailed out by governments at the cost of hundreds of millions of dollars.

CLOs could be the instruments that spark a collapse in financial markets.

Frank Kane

In place of mortgages, CLOs substitute corporate bonds. Since the end of the global financial crisis corporates have been raising funds through debt issuance at an accelerating rate. In an era of quantitative easing and low interest rates, it made sense.

Banks were happy to get involved in the syndicated loans that formed the basic ingredient for most CLOs, and the private equity industry liked them too as a cheap way of funding corporate mergers and buy-outs.

Recent estimates from the US Federal Reserve indicated that there was more than $10 trillion of corporate debt in existence at the end of last year, 80 percent up from levels immediately after the global financial crisis.

The pandemic has accelerated the rate of debt-issuance as companies rush to fill up the coffers ahead of an anticipated funding squeeze later in the year. The Middle East has been prominent among those issuing corporate debt. Although CLOs are not a common investment instrument in the region, the Gulf financial system would be just as exposed as anywhere else if things go wrong.

Nobody is saying a CLO collapse is just around the corner. Banks and credit rating agencies learned a lot from the global financial crisis and have put in place more stringent rules about these kinds of financial instruments.

The US Fed has taken serious steps to prop up not just equity and bond markets generally, but even extending some of their multi-billion-dollar support to sectors politely called “high yield” but often referred to as “junk bonds.” These steps have so far worked and are the main reason why stock markets are heading back toward record levels even as the global economy languishes.

But it is not difficult to imagine a scenario where this could change pretty rapidly: Half-year corporate earnings collapse under the weight of the pandemic, the ratings agencies downgrade the creditworthiness of those corporate issuers, which default on their obligations causing a cascade of financial problems for the CLO holders, such as big banks and private equity companies.

If the global re-opening accelerates and economic activity recovers, this scenario will probably never come to pass. But it is a risk that should not be ignored.

  • Frank Kane is an award-winning business journalist based in Dubai. Twitter: @frankkanedubai.


Most Popular

return to top