The public keeps losing and losing and losing to big finance because financiers have made an art form of using complexity, opacity, and leverage to cover their tracks.
The last example comes in an anodyne-seeming article in the Financial Times about collateralized loan obligations, or CLOs. CLOs are a structured credit product, in this case, made from leveraged (as in risky) corporate loans. Think of it as the corporate lending analogy to subprime bonds. The major differences between CLOs and RMBS are that CLOs are not secured by collateral (houses) and that CLOs turned out to be much better diversified than RMBS (the mortgage bond designers thought that a geographic mix would provide adequate diversification, since the modern US had never suffered a nation-wide housing market price decline. Whoops!)
CLO volumes exploded in the runup to the crisis due to a cheap-debt-fueled M&A boom, with private equity firms the big source of increased deal demand. And when the music stopped, the big banks were stuck with lots of unsold inventory. While their losses were no where near as bad as the ones they suffered on CDOs, they were still well above what was thought to be consistent with AAA rated paper. In the spring and summer of 2008, Bloomberg would report intermittently on the sorry state of the CLO market, with prevailing prices in the mid to low 80s. There were also reports of dealers selling small lots to compliant hedge funds at inflated so they could use those values to justify the marks on their positions.
Now the banks seem to have amnesia as far as the crisis is concerned, but US regulators (at least for the moment) have taken an uncharacteristic interest in reducing the risks banks carry, including those of CLOs. But the unfortunate aspect of the discussion in the Financial Times, and we assume elsewhere, is that this issue is being framed too narrowly, as being a matter of bank and financial system safety. Absent is the notion of the societal cost of making cheap debt too readily available to what in the 1980s were called takeover artists.
As an unnamed insider noted in Ron Suskind’s Confidence Men, private equity depends on being able to load companies up with debt, and (according to him) only one in ten deals needs to succeed for the fund to do well. Many industry professionals would argue a bigger proportion of deals to work out for a PE player to be deemed successful, but the general point still holds: a leveraged buyout firm can drive a lot of companies into the ditch and still come out a winner. And low cost debt allows them to operate at a much higher level of activity. As we noted in ECONNED:
Cheap funding similarly played a major role in the breakneck pace of mergers and acquisitions, which became more and more frenzied until the onset of the credit contraction, in the summer of 2007. Global mergers for the first six months of 2007 were $2.8 trillion, a remarkable 50% higher than the record level for the same period in 2006. And takeovers for the full year 2006 ran at a stunning seven times the level seen four years prior.
The EU has decided it does not like the nasty propensity of PR funds to lever up corporations, pull out a lot in the way of special dividends, and too often overdo the cash extraction and leave a bankrupt hulk in their wake. The EU has been working on a proposal to restrict investors in the EU from putting funds in private equity and hedge fund firms outside the EU, and also limit the ability of foreign investors to buy European companies. The response was huffing and puffing, that this move would “seriously disturb” the biggest PE firms. So? That was the plan, wasn’t it?
But in the US, the home of the biggest players, you hear nary a peep of this sort of talk, one that would likely argue for even bigger curbs that the ones being contemplated (and sure to be watered down). And the banks are certain to fight hard against any restriction, because M&A is a source of big advisory fees as well as new issue profits. Key extracts from the Financial Times:
Wall Street is set to pick another fight with regulators as the loan industry and big banks push back against new rules that they say could limit lending to companies with low credit ratings…
The desire among regulators – the Federal Reserve, Federal Deposit Insurance Corp and Office of Comptroller of the Currency – to prevent another financial crisis carries the risk of unintended consequences; namely that tough rules could impair market liquidity and ultimately hurt the broader economy.
Yves here. Ah, yes, the perennial threat: cut off our cheap leverage, and you’ll damage the economy. I’d love to see an analysis of how many levered loans went to fund corporate investment as opposed to takeovers (although the percentages deemed a failure vary, pretty much every study that has looked at corporate takeovers has concluded that most fail, so discouraging corporate acquisitions would also be salutary).
The FT article does mention, in a single sentence, that the levered loans used in CLOs stoked acquisitions during the credit bubble. But the political argument is over a proposed increase in capital for CLOs kept on bank balance sheets as a way to reduce systemic risks. This debate may seem a bit overdone, since CLO issuance was a mere $12.5 billion this year versus $97 billion in 2006. But in many ways, these debates are not simply over how the rules should read, but what form of capitalism will have. And unfortunately, despite occasional tough gestures by regulators, the framework and assumptions that produced the last crisis remain largely intact.