Financial engineering made risky loans safe. Now they face a huge test.

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Cirque du Soleil canceled its famous shows in Las Vegas and around the world last week, leaving fans disappointed. More than 100 investment funds also suffered as the value of loans from the circus plummeted.

The company is one of thousands of companies whose loans have been bundled with equally risky, fund-listed debt, which have then been sold to investors around the world.

Some popular loans among CLOs have seen steep price declines

BCP Renaissance Parent

Owned by 203 CLO*

Price drop†

-16.0 cents on the dollar

McDermott International

155 CLOs

American Intermediary CDS

Contributions (Cirque du Soleil)

117 CLOS

GIP III Stetson I

127 CLOS

Field wood energy

90 CLOs have two loans

The idea behind these funds, known as Secured Loan Obligations or CLOs, is that it is extremely unlikely that different companies will all run into trouble at the same time. By pooling and diversifying their holdings, these funds could turn risky loans into safe, well-rated investments that offer better returns than Treasuries.

CLOs have exploded in recent years as investors seek income in a world of rock-bottom interest rates. This boom, in turn, fueled the demand for risky leveraged loans. The rapid growth has led global regulators to warn of potential building instabilities in the financial system. The Bank of England has even compared the sector to the subprime mortgage boom before the 2008 financial crisis.

Then came the coronavirus. Its broad impact on all sectors – canceling flights, dumping conferences, jamming vacations, closing restaurants, dumping cruise lines and closing schools and offices – threatens to undermine the key assumption that allows CLOs to turn risky loans into triple-A rated investments: that diversifying loan holdings will protect investors.

“These things were structured for perfection, for good economic times,” said John Griffin, a finance professor at the University of Texas at Austin who has studied the CLO market. He thinks many CLOs are likely to suffer losses, although others in the industry say it’s too early to tell.

The cancellation of the Cirque du Soleil show made his already risky debt harder to repay. The price of its senior term loan fell to 69.5 cents on the dollar after the cancellation of issuances, from 92.5 cents on Feb. 27, according to Trepp CLO, which tracks the industry. On Wednesday, the rating firm Moody’s Corp.

cut Cirque du Soleil’s rating deep into speculative territory, citing a “wide deterioration in credit quality” triggered by the coronavirus pandemic.

A Cirque du Soleil spokeswoman said the company was “working day and night to manage this difficult situation” and declined to comment further.

While not as big as the sub-prime mortgage market that battered the US economy a dozen years ago, the CLO business has become big business. Financial engineers have fabricated over $700 billion in CLO debt in the US and Europe in recent years. Well-known managers include Blackstoneit is

GSO Capital Partners, Neuberger Berman and Eaton Vance Corp.

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According to the International Monetary Fund, in recent years these funds have purchased more than half of all leveraged loans, a risky type of debt used by private equity firms to make buyouts. For example, private equity firm TPG purchased Cirque du Soleil in a 2015 deal that saddled the circus with nearly $900 million in debt that was later bought out by dozens of CLOs.

TPG declined to comment.

A CLO works like this: the fund manager collects hundreds of risky loans from different borrowers. It then repackages them into triple-A rated paper, backed by smaller, riskier tranches of lower-rated paper and stocks, which are sold to investors. Banks in the United States and Japan, insurance companies, hedge funds and fund managers have piled in as CLO investors.

Cash flow collected on all loans is first used to pay for the highest rated paper. If there is a problem with the underlying loans, the riskiest bonds, which are lower rated, are not paid. No triple-A rated CLO bond has ever defaulted, according to rating firm S&P Global Inc.

CLOs existed before the financial crisis, but have grown in popularity in recent years. This has created a credit well for risky businesses to tap into. As CLOs competed for loans to invest in, borrowers could take on more debt per dollar of income at lower rates and demand looser terms, called covenants.

The industry now faces impending problems. Lots of funds invested in the same loans, so one big default will lead to losses for many. The top 20 loans that saw the biggest price declines from Feb. 27 to March 11 were spread across nearly 500 funds, according to Trepp data. Trepp tracks 1,250 CLOs, or around 85% of the market.

Geoffrey Horton, CLO analyst at Barclays, says lack of concentration in one industry should protect investors. The largest industry concentrations in US CLOs are healthcare and pharmaceuticals at 12.5% ​​for the median fund, followed by high tech at over 10%. These are industries that could partially benefit from the coronavirus pandemic. Frontline industries, such as hospitality, gaming and leisure, retail, energy and consumer goods, and transportation, account for a combined total of 14.8%.

Another issue is that the industry may have underestimated the likelihood that different industries could face challenges simultaneously when an unexpected event like the coronavirus hits.

“If you think of a ‘black swan’ event, I mean this will be the event,” Jaret Seiberg, an analyst at Cowen Washington Research Group, said at an investment conference in Las Vegas in February.

A 2017 study of 136 post-crisis CLO transactions found that the default correlation assumptions should have been three to four times larger than those used by S&P. According to Mr. Griffin of the University of Texas, who co-authored the study.

An S&P spokesman said “we are not commenting as we are facing a major crisis rocking financial markets.”

The Treasure Island hotel in Las Vegas announces Cirque du Soleil’s Mystère show on Saturday.


Photo:

Ethan Miller/Getty Images

Avoiding a sudden increase in defaults across the board is crucial for CLOs, as an expected low correlation between subprime borrowers is what allows their debt to be pooled and carved into safer investments.

Joe Pimbley, credit risk consultant at Maxwell Consulting in New York, said correlations are hard to get right. Subprime mortgage bonds suffered losses in 2007 and 2008 because investors, banks and rating agencies incorrectly assumed that many homeowners were unlikely to default at the same time in the United States, a he declared.

“The bottom line is that we don’t know the correlations. The best we can do is make our best guess,” Pimbley added.

CLOs performed well during the last crisis. While the underlying loans held by funds are arguably riskier than before, CLOs have adopted features to better protect investors, such as larger tranches of low-rated debt that protect bondholders. triple A against losses.

“The structures are very well designed to handle situations like this,” said Tom Majewski, managing partner of Eagle Point Credit Management LLC, which has about $2.9 billion invested in stocks and CLO tranches less well noted.

Write to Cezary Podkul at [email protected] and Paul J. Davies at [email protected]

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