Is packaging a bunch of loans together really SAFE? There's more to this strategy than meets your eye…
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From the desk of Miles Everson: Hello! Welcome to “The Independent Investor!” I’m excited to talk to you about today’s investment insight. In these articles, I share all-things finance and investment to help you experience financial freedom and achieve financial stability in the long run. Are you ready for today’s topic? If you are, then continue reading below! |
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Is packaging a bunch of loans together really SAFE? There's more to this strategy than meets your eye… Have you heard of the term “vampire squid” in finance? For those of you who haven’t yet, “vampire squid” is a nickname given to investment banking company Goldman Sachs by journalist Matt Taibbi in a 2009 article he wrote for the Rolling Stone magazine. In his article, Taibbi described Goldman Sachs as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” According to an article from The Economist, the description stuck not only because it was vivid but also because it was a little bit true. … but did you know that recently, another “vampire squid” has emerged in the industry? It’s none other than private equity (PE) giant Blackstone (BX).
According to Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist of Altimetry Financial Research, BX is diving deeper into private credit. In fact, an article from the Financial Times states that the firm is close to raising nearly USD 400 million for its flagship Blackstone Private Credit Fund (BCRED), and this will allow the firm to keep making HUGE multi-billion-dollar corporate loans to clients. Professor Litman says this strategy isn’t ridiculous by itself. Aside from BX, banks use this approach ALL THE TIME. The real issue is that BX is backing its loans with more loans. Uh-oh… The firm is putting some of BCRED’s current loans into something called a collateralized loan obligation (CLO). Basically, what BX does is packaging a bunch of the loans together, turning that into a financial security, and selling shares of that security to other investors to fund future loans. Does that sound a bit risky? Well, it does! Professor Litman states this type of investment vehicle is what caused the Great Recession of 2008 to be so brutal and complex. … and as we’ll explain further, it seems as though the PE market has forgotten such risks. Making Securities Look “Safer” Than They Are In 2019, Banco Santander (SAN) bundled thousands of subprime auto loans into a bond product called “Drive 2019-3.” Combined as one security, these loans were considered “safe.” As long as no more than 60% of that portfolio defaulted, bondholders would get their money back. That same phenomenon is happening in the private-credit world in recent times. For instance: Blackstone is moving some of BCRED’s loans into a CLO to raise more money. This includes debt from companies such as software maker Zendesk, cybersecurity company Mimecast, and health care management provider Unified Women’s Healthcare. Bucketing all of these loans together makes them look “safer” as a whole. Think about this: Even if one loan defaults, it’s only a small part of the whole instrument. … but still, this doesn’t change the fact that a HUGE part of the CLO is risky. CLOs are structured a lot like collateralized mortgage obligations (CMOs), which gained popularity right before the Great Recession. CMOs were created as a way for banks to offer investors access to varied-risk mortgages. These ended up being a major reason why the Great Recession was so extreme. Allow us to explain a bit more… Starting in 2007, many CMOs began including low-quality subprime loans that received “safe” credit ratings when bundled together—similar to what’s happening with CLOs. The only difference is that CMOs were backed by mortgages rather than corporate loans. Eventually, those CMOs started getting riskier, and ratings agencies didn’t catch on. Rather than just investing in mortgages, CMOs started investing in one another. Such a convoluted web made it harder to understand how risky these instruments actually were. So, when consumers started defaulting on their mortgages, CMO values dropped, causing a chain reaction of investor losses that sparked the financial crisis. That’s why BX’s latest foray into CLOs shows PE firms are getting desperate… About 20% of the BCRED CLO is rated “extremely speculative” or worse. That’s way higher than the typical threshold for CLOs that hold publicly traded bonds, which is about 7.5%. Bank of America projects the highest annual issuance of private credit CLOs ever this year (2024). So, this is an IMPORTANT trend to watch out for! The economy will be walking a fine line as more and more PE firms turn to CLOs to raise cash. What’s more? If CLOs end up powering the PE market, it could end with an even more painful recession than expected. Hope you’ve found this week’s insights interesting and helpful.
Stay tuned for next Wednesday’s The Independent Investor! A CDS is a type of financial derivative that allows an investor to offset credit risk with another investor. It provides insurance against the risk of a default by a particular company or by companies of different sizes. Learn more about why banks will most likely save their biggest customers first in next week’s article! |
