The trillion-dollar bet: 17 years after the financial crisis, securitized loans are once again causing nervousness.

Jamie Dimon speaks his mind. When the American auto parts supplier First Brands went bankrupt this fall and defaulted on its loans, the CEO of JP Morgan bank declared in a conference call with investors: “I probably shouldn’t say this, but if you see one cockroach, there are probably more. Everyone should be aware of that.” Dimon was alluding to 2007, when the first hedge fund bankruptcies triggered the global financial crisis.

Cockroaches hide where it's warm and there are food scraps. Finding bad corporate loans is more difficult.

First Brands , a manufacturer of spark plugs, windshield wipers, and other small automotive parts, had raised over $10 billion in debt but concealed the true extent of its debt from its creditors. The company filed for bankruptcy on September 28.

First Brands' non-performing loans were, among other things, tied up in supply chain financing vehicles. These provide advance liquidity to companies that don't want to collect unpaid invoices themselves. At least $2.6 billion was also invested in over 1,000 collateralized loan obligations (CLOs). These are financial vehicles that pool numerous bank loans to heavily indebted companies and resell them to investors.

The main selling point of CLO issuers is this: those who invest their money across several hundred loans won't be derailed if a handful of them default. Furthermore, CLOs are structured in such a way that risk-tolerant investors absorb the majority of the defaults, while all other shareholders with less risky "tranches" remain unaffected.

CLOs can therefore sell a large portion of their own bonds with a triple-A rating, which corresponds to the highest credit rating, even though they mostly invest in loans below investment grade, i.e., in borrowers with ratings in the BB or B range. CLO AAA tranches offer a higher yield than conventional AAA bonds.

This works well: The market – both in the US and internationally – has boomed in recent years and grown to over one trillion dollars. Investors are betting that securitized loans have a future. The annual growth rate of the CLO market is around 10 percent.

However, some voices see a dangerous negligence in the market regarding securitized corporate loans. They fear a repeat of the global financial crisis. One of them is the American finance professor John M. Griffin. After the 2008 crisis, he advised the US Department of Justice in its investigations against the rating agencies and now teaches at the University of Texas.

“It all feels like déjà vu,” Griffin told the NZZ. “When I look back at the financial crisis and then at today’s market, I see almost the same problems.” The only thing missing so far to expose the weaknesses of the CLO structures is that there hasn’t been a major collapse yet: “One day it will happen, and then people will say: Wow, that’s truly unbelievable.”

Marc Chesney, emeritus professor of finance at the University of Zurich, expresses a similar view: "CLOs are nothing more than old ideas in new packaging." Securitizing loans creates incentives not to analyze individual debt contracts closely enough. "When a crisis hits, the diversification suddenly disappears."

Griffin and Chesney have no historical evidence to support their pessimistic assessments. To this day, the proponents of CLOs have been proven right: A CLO triple-A bond has never defaulted. Even during the global financial crisis, CLOs withstood the turbulence. Nevertheless, to understand the risks of these products, it is worthwhile to look at the past.

At the beginning of the global financial crisis of 2007 and 2008, there were vehicles that are similar in many respects to today's CLOs. Back then, they were called Collateralized Debt Obligations (CDOs). Instead of corporate loans, they bundled mortgages. Their credit rating was also lower than that of the bonds subsequently sold to investors. The issuers also argued that the large number of mortgages reduced the risk for the individual creditor. The magic word then, too, was diversification.

This proved to be a misconception: when the financial crisis erupted, far more mortgages defaulted simultaneously than the models had predicted. This was partly due to the fact that the issuers of the CDOs had included mortgages from homeowners with disastrous credit ratings in their products. The rating agencies failed to foresee the impending catastrophe and assigned the highest credit ratings to the CDO tranches.

In "The Big Short," actor Ryan Gosling explains the cause of the global financial crisis this way: "With CDO, we take a bunch of B and BB-rated bonds that haven't sold and put them in a pile. If the pile is big enough, the whole thing is suddenly considered diversified. And the rating agencies give it a AAA rating. Without asking any questions."

Today, representatives of the CLO market and rating agencies dismiss comparisons to the 2008 financial crisis as fear-mongering. Following the default of the First Brands loans, they expressed confidence that it was an "idiosyncratic isolated incident." The share of First Brands loans in most CLOs averages 0.5 percent.

But was it just a single cockroach? Rating agency Moody's emphasized that the concentration of First Brands loans in most CLOs was "relatively modest" and that the diversification built into the CLOs protected investors. An S&P Global representative wrote on LinkedIn after the bankruptcy: "Asset diversification and other structural features limit the risk for most CLOs." Rating agency Fitch also described the impact of the First Brands bankruptcy on the CLO market as limited.

Pascal Böni, a finance professor in Basel, shares this view. He does not consider the CLO market, estimated at between several hundred billion and over 1 trillion dollars, a threat to the global financial system. "For comparison," he says, "the global stock market comprises approximately 130 trillion US dollars, and the global bond market about 145 trillion US dollars." The market for CLO products is growing disproportionately fast, but the quality of the loans remains stable.

However, the fact is that the CLO market is already larger today than the CDO market was in 2007.

Böni, however, finds it problematic when banks invest heavily in CLO vehicles to optimize their equity management. "A bank that previously granted a loan directly to an SME now packages this loan into a structured tranche because it then has to set aside less regulatory risk capital." This could create a new, previously underestimated risk.

John Griffin, however, believes that the CLO market could one day explode. Based on his analysis, he is convinced that in the next systemic crisis, the loans in CLO vehicles will default more frequently simultaneously than the rating agencies' models predict. This is because not only the CLO bonds themselves, but also the loans in the CLO vehicles are overvalued.

According to Griffin, a new financial crisis could have erupted as early as the beginning of the Covid crisis in the first quarter of 2020. At that time, however, central banks lowered interest rates so drastically and governments increased public spending so significantly that it amounted to a collective bailout.

In a research paper, Griffin criticizes the rating agencies for not downgrading the CLO tranches quickly enough, just as they did during the financial crisis. He assumes they are still caught in the same conflicts of interest as 18 years ago. The rating agencies declined to comment when contacted by the NZZ, referring instead to their research reports.

Meanwhile, a growing number of investors are gaining access to CLO structures. This summer, the Swiss banking giant UBS launched a CLO ETF that invests in triple-AAA tranches of CLO vehicles. It promotes the ETF by claiming that AAA-rated CLO tranches offer a higher return than corporate bonds with comparable ratings. The bank emphasizes on its website that since the market's inception, there has never been a default on a AAA-rated CLO. To date, investors have invested slightly less than €100 million in the ETF.

When contacted by the NZZ, the bank declined to comment: "It is correct that we have launched such a product. Thank you for your understanding that we cannot provide any further information."