Posted 06/19/2020

Path Forward & CLO Market Education

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Bubble CLO Market Path

A quick recap of a recent conversation on Telegram that revolved around the path forward and the weakest links -- notably CLOs, and the risk of an unwind as defaults rise.

Path Forward & CLO Market Education [Telegram]

  • Recap: We’ve gone through Phase 1 (liquidation; sell all assets at any cost), we’re in Phase 2 (recovery; equity markets rallying, extrapolating near term data points perpetually into future), and we likely enter Phase 3 sometime this fall (August+). The exact path forward is uncertain, but we should all be prepared for the potential outcomes so we make the right allocation decisions at the right time.

  • Comment: The risk we still have ahead is an insolvency crisis – hopefully that is not the case, but it’s something to monitor, particularly as the market implied probability of any issues continues to drop off… right at the same time that extended unemployment benefits roll off, forbearance expires, COVID cases pick back up. Net net, buying the re-opening rumor has certainly worked well – the question to ask from here is, will the news disappoint? What are the risks that were front and center 3 months ago, but now have been completely forgotten about (e.g. CLO system)?

  • Highlights:

    • The global economy was in a fragile state heading INTO *the coronavirus - the pandemic itself just provided the shock to a late cycle economy (pin that pricked the balloon*)


      • Phase 1: Virus hits late cycle economy; everything shuts down all at once - total risk off; sell assets at any price (liquidation)



        • This phase lasted about ~1 month before the Fed “caught up” at the end of March





      • Phase 2: Fed & Government steps in w/ “infinite” balance sheet; the data points continue to get “better” off of a very easy base - capital markets wide open + risk assets rallying, discounting V-shape recovery



        • This is the phase we’ve been in for the past ~2.5 months





      • Phase 3a: Data continues to improve, more fiscal stimulus is passed (extra unemployment benefits extended, etc.), forbearance is extended, unemployment rate drops, capital markets stay open – the market likely continues to grind higher, with a bias toward reflation (cyclicals)



        • This is the phase most hope we are entering / is a continuation of Phase 2





      • Phase 3b: Data begins to flat-line / rollover, fiscal stimulus bill disappoints (extra unemployment benefits end, etc.), forbearance ends, unemployment rate flat lines, capital markets close – rates likely go negative, the equity markets sell-off, the USD rips higher



        • This is one of many potential possible paths forward. It’s not the highest probability, but the probability rises as lockdowns extend



    • It’s unclear the exact path forward – all you can do is continue to measure and map the highest probability path forward – but you should be prepared for the various paths so you know how to take action

      • As of now, the highest probability path appears to be one of stagflation – input costs (commodities) start rising, while growth flat lines / stagnates

    • Just like many thought the world was fine / the worst had passed post the Bear Stearns collapse (March 2008; market rallied ~10% into the summer), the Lehman shoe had yet to drop (September 2008; market dropped 50% over next 6 months)
    • It would have been great to have been educated on the intricate housing system in 2008… and today, we think it makes sense to read up on the CLO (collateralized loan obligation) industry
    • The Fed has knowingly created and inflated a massive corporate debt bubble – they know if it pops, we have serious issues… a vicious cycle that would take down the pension system and potentially the entire financial system. They will obviously do everything they can to avoid this scenario.
    • The game being played right now is a game of narratives and posturing by leaders (Trump, Powell, Mnuchin, etc.). But what happens when people need to start paying their auto loans, mortgages, and student loans again? What happens if extra unemployment benefits roll off and there aren’t jobs for the 40M+ who have filed claims? What happens when this ‘extended paid vacation’ – where incomes are UP 10%+, major expenses are DOWN (auto, mortgage, etc.), and free time is UP – for many ends?

      • Not saying this doom loop is definitively going to happen, but everyone should be prepared for how to position if it does

      • The current market price implies the probability of “Phase 3b” has dropped dramatically… and the market appears to be extrapolating current data points / trajectory into the future

    • If the path forward is some version of the above “Phase 3b,” *then you can make (or save) a lot of money understanding the CLO industry structure and who is most vulnerable. *It pays to pay attention to areas where others are NOT, and make bets where odds are in your favor.
    • To that end, check out some of the articles below to get a better understanding of the CLO market (the potential weak link in a tenuous chain):
      • The Looming Bank Collapse

        • With rates at 0, corporates and now governments over-levered, an unwind of the CLO market could be catastrophic to the current financial system
        • Article provides a good overview of the CLO system. It is a bit dramatic, for obvious reasons – sensationalism sells clicks
      • Is There Really A “Looming Bank Collapse?”

        • Response to the article above – takes the other side
        • He makes some good points re framing. But his analysis overall is incomplete – particularly as it relates to the interconnectedness and liquidity of the system
      • Those $700B in US CLOs: Who holds them, what risk they pose

        • More generic breakdown of the industry / holders (as of June 2019)