The Central Bank, Dublin
‘Ragamuffin’ writes:
The Atlantic magazine this month has an interesting article entitled “The Worst Worst Case Scenario” (or for the online version “The Looming Bank Collapse” ) by UC Berkeley Law Prof Frank Partnoy.
In the article he outlines the possibile scenario in which the coronovirus crisis leads to another 2008 style recession, except this time it would be worse.
He explains that the last financial crash was largely caused by bank’s over investment in CDOs:
“The financial crisis of 2008 was about home mortgages. Hundreds of billions of dollars in loans to home buyers were repackaged into securities called collateralized debt obligations, known as CDOs.
In theory, CDOs were intended to shift risk away from banks, which lend money to home buyers. In practice, the same banks that issued home loans also bet heavily on CDOs, often using complex techniques hidden from investors and regulators.
When the housing market took a hit, these banks were doubly affected. In late 2007, banks began disclosing tens of billions of dollars of subprime-CDO losses. The next year, Lehman Brothers went under, taking the economy with it.”
This process of contagion and collapse was memombarbly explained by Ryan Gosling’s character using Jenga blocks in The Big Short (2015).
According to Partnoy, the current threat is CLOs, which seem to share more than just a similar name with CDOs:
“After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world.
These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.”
Partnoy warns that if the leveraged loan market collapses, many banks will have liabilities greater than their assets. And due to the current Covid 19 situation…
“…the outlook for leveraged loans in a range of industries is truly grim”.
He warns that if another financial crash is looming, politicians will be under tremendous pressure to NOT bail out the banks, due to citizen’s anger at lessons not being learned by banks in 2008, adding:
And then, sometime in the next year, we will all stare into the financial abyss. At that point, we will be well beyond the scope of the previous recession, and we will have either exhausted the
remedies that spared the system last time or found that they won’t work this time around.”
Partnoy summary at the end of the article calls for major reforms of our financial system, whether the crash happens or not:
“It is a distasteful fact that the present situation is so dire in part because the banks fell right back into bad behavior after the last crash—taking too many risks, hiding debt in complex instruments and off-balance-sheet entities, and generally exploiting loopholes in laws intended to rein in their greed. Sparing them for a second time this century will be that much harder.
If we muster the political will to do so—or if we avert the worst possible outcomes in this precarious time—it will be imperative for the U.S. government to impose reforms stringent enough to head off the next crisis. We’ve seen how banks respond to stern reprimands and modest reform. This time, regulators might need to dismantle the system as we know it.
Banks should play a much simpler role in the new economy, making lending decisions themselves instead of farming them out to credit-rating agencies. They should steer clear of whatever newfangled security might replace the CLO. To prevent another crisis, we also need far more transparency, so we can see when banks give in to temptation. A bank shouldn’t be able to keep $1 trillion worth of assets off its books.
If we do manage to make it through the next year without waking up to a collapse, we must find ways to prevent the big banks from going all in on bets they can’t afford to lose. Their luck—and ours—will at some point run out.”
I have to admit, I have no expertise in financial issues. So by the end of the article I was hoping CLOs were an American phenomenon, and that Irish banks would not be so foolish to get involved in this market, after the last devastating collapse.
I googled CLO Ireland and found this Irish Times article from last December titled “Central Bank warns on Dublin’s €78bn company loans hub” .
The article by Joe Brennan states:
“Ireland’s growing role as a host to esoteric vehicles for repackaged loans of highly indebted companies internationally could see it caught up in an international financial shock if corporate default rates spike. US and British private equity firms and asset managers have driven a boom in collateralised loan obligations (CLOs) vehicles in Ireland in recent years.
These repackage pools of corporate loans into bonds that are sold to investors. Total assets in Irish-based CLOs spiraled to €78 billion in first quarter of 2019 from €15.7 billion five years’ earlier.
An estimated two-thirds of the outstanding value of European CLOs is now domiciled in the Republic, the Central Bank said in a paper published on Friday on Ireland’s market-based finance, or shadow banking, industry.”
Brennan goes on to play down the risk CLOs pose to the Irish economy:
“Only a tiny portion of non-bank finance assets in Ireland relate to the domestic economy…While the prospect of an entity in the International Financial Services Centre (IFSC) imploding would cause more reputational damage than a direct cost for Irish taxpayers, the new Central Bank governor Gabriel Makhlouf has set a priority on assessing the risks in the sector, including parts, such as CLOs, that are not regulated.”
I hope Joe Brennan is right, but would the main learning from 2008 not be that if the jenga bricks begin to fall in America, then the whole world (including Ireland) is coming down too?
It would seem to me that Ireland should be doing more to regulate CLOs if we are the European leader in their sale. I would be very interested to Ask A Broadsheet Reader what they make of this.
Meanwhile…
Not really close to being a ‘huge’ concern. Banks exposure to these is small (ca 45% of AAA rated slice of the market and virtually nothing of the rest of the market). Total market size is about 1/3rd of CDOs that blew up in GFC. U.S. banks hold ca 90 billion or 13%. +
— Constantin Gurdgiev (@GTCost) June 17, 2020
+ quantum of losses they can trigger is small. Too small for the banks to worry about. More dire, from the banks systemic risk perspective, are their capital cushions and any potential pressures on liquidity. Separate story.
— Constantin Gurdgiev (@GTCost) June 17, 2020
Fight!
Update:
Not at all. I had my former students working these days in big US banks all panicking over their careers and their jobs over that Atlantic article. IMO, systemic risks in other areas, e.g. overall corporate & government bond markets, are more pressing than CLOs, though CLOs +
— Constantin Gurdgiev (@GTCost) June 17, 2020
+ can create some pressures. Central Banks can monetize this asset class relatively easily, however. For Ireland, 76bn in CLOs is not hugely indigenous: https://t.co/DUOQcrdjVR. So a lot of this is IFSC stuff.
— Constantin Gurdgiev (@GTCost) June 17, 2020
Uh-oh….
It’s Partnoys complaint.
If you regulate it you own it, if you dont…
Looks like great read, very little ‘stress’ at moment in US banking system-but its early days and the feds have flooded the system with cash.
Just so that ye know
What ye’ve been calling Vulture Funds
Not only have their profits protected by way of favourable incorporation/ legal identity permissions that facilitate Tax calculations
Their losses are also guaranteed
For which they can also thank Michael Noonan for
And apparently the Banking Culture Board will only talk of it outside the room
as it were
Maybe one of ye can get John Hedigan into rounds sometime
and get him talking
Now look at the Programme for Government again.
remember the real enemy, “welfare cheats, cheat us…..”
So the issue was not resolved and will have to be met again. It would be helpful if eu could simply use our position with two thirds of CLO market to effectively restrain these practices. But does it also suggest that as a little island away from continental Europe that ireland represents a viable channel to locate these lucrative practices, as it were ‘off shore’? That doesnt sound good if as a believer in the benefits of the eu to a country like ireland the question is not about our membership but our usefulness.
On the Central Bank’s own website in Nov 2019 they say the following, and I wonder does this sound to anyone else like they’re getting worried?
“Recent growth in corporate indebtedness has been identified by the European Central Bank, US Federal Reserve, Bank of England and Central Bank of Ireland as a potential financial stability risk. Specifically, they have highlighted the growing size of the market for leveraged loans. These are subprime loans provided to borrowers who already have significant debt, or have a poor or non-existent credit history. A significant portion of leveraged loans are syndicated, which means that there are multiple lenders providing the loan.
One driver of the growth of leveraged loans has been the demand for bonds backed by portfolios of syndicated loans, known as collateralised loan obligations (CLOs). CLOs may amplify the spread of risk throughout the financial system due to uncertainty over who is exposed to them. During periods of market stress, this uncertainty can exacerbate financial institutions’ unwillingness to do business with each other. For this reason, institutions such as the Bank for International Settlements have compared CLOs to collateralised debt obligations, which had a pivotal role in spreading stress through the financial system during the global financial crisis.”
The term ‘subprime loans’ still sends shivers down my spine after the last crash (as will the term ‘novel corona virus’ for the foreseeable future).
It’s worth clicking on the link and scrolling down to see the graphs. The scale of the growth is pretty dramatic (to say the least): https://www.centralbank.ie/statistics/statistical-publications/behind-the-data/the-whos-who-of-irish-collateralised-loan-obligations
I agree with Constantin G about the portfolio proportion of and extra-territoriality of and risk factors of the CLOs currently warehoused in “Ireland”. These are financial and economic arguments.
Bear in mind that in a crisis, political factors outweigh all theoretical arguments and often outweigh rationality.
In the crisis of 2008-10, at least half the assets of the Irish banks were extra territorial and were low risk property backed.
A political judgement in Berlin forced the hand of the ECB and the Irish people / taxpayers were forced to make good the foolish / greedy yield seeking of German depositors on a wholly disproportionate basis.
Nothing has changed that would prevent that outcome being forced upon Ireland when the coming crisis unfolds
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