After months of living with

The U.S. banking

The system could be
the coronavirus pandemic,
American citizens are well
aware of the toll it has taken on
on the cusp of
Worst calamity. This time,
the economy: broken supply
chains, record unemployment,
failing small businesses. All of
these factors are serious and
we might not be
Worst able to save it.
could mire the United States
in a deep, prolonged recession.
But there’s another threat to
the economy, too. It lurks on

Case the balance sheets of the big

banks, and it could be cataclys-
mic. Imagine if, in addition to
all the uncertainty surrounding
the pandemic, you woke up one
morning to find that the finan-
cial sector had collapsed.
You may think that such a
crisis is unlikely, with memo-
ries of the 2008 crash still so
fresh. But banks learned few
lessons from that calamity,
and new laws intended to
keep them from taking on too
much risk have failed to do
so. As a result, we could be on
the precipice of another crash,
one different from 2008 less in
kind than in degree. This one
could be worse.
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
By Frank Partnoy losses. The next year, Lehman
Brothers went under, taking the
economy with it.

ILLUSTRATIONS BY GEORGE WYLESOL 41

 The federal government stepped in to rescue the the CDO market in 2007 at
other big banks and forestall a panic. The intervention $640 billion; it estimated the
worked—though its success did not seem assured at overall size of the CLO mar-
the time—and the system righted itself. Of course, ket in 2018 at $750 billion.
many Americans suffered as a result of the crash, los- More than $130 billion worth
ing homes, jobs, and wealth. An already troubling gap of CLOs have been created
between America’s haves and have-nots grew wider still. since then, some even in recent
Yet by March 2009, the economy was on the upswing, months. Just as easy mortgages
and the longest bull market in history had begun. Just as easy fueled economic growth in
To prevent the next crisis, Congress in 2010 passed the 2000s, cheap corporate
the Dodd-Frank Act. Under the new rules, banks were mortgages fueled debt has done so in the past
supposed to borrow less, make fewer long-shot bets, decade, and many companies
and be more transparent about their holdings. The economic growth have binged on it.
Federal Reserve began conducting “stress tests” to
keep the banks in line. Congress also tried to reform
in the 2000s, Despite their obvious
resemblance to the villain
the credit-rating agencies, which were widely blamed cheap corporate of the last crash, CLOs have
for enabling the meltdown by giving high marks to been praised by Federal
dubious CDOs, many of which were larded with sub- debt has done Reserve Chair Jerome Powell
prime loans given to unqualified borrowers. Over the and Treasury Secretary Steven
course of the crisis, more than 13,000 CDO invest- so in the past Mnuchin for moving the risk
ments that were rated AAA—the highest possible
rating—defaulted.
decade, and many of leveraged loans outside the
banking system. Like former
The reforms were well intentioned, but, as we’ll companies have Fed Chair Alan Greenspan,
see, they haven’t kept the banks from falling back into who downplayed the risks
old, bad habits. After the housing crisis, subprime binged on it. posed by subprime mortgages,
CDOs naturally fell out of favor. Demand shifted to Powell and Mnuchin have
a similar—and similarly risky—instrument, one that downplayed any trouble CLOs
even has a similar name: the CLO, or collateralized could pose for banks, argu-
loan obligation. A CLO walks and talks like a CDO, ing that the risk is contained
but in place of loans made to home buyers are loans within the CLOs themselves.
made to businesses—specifically, troubled businesses. These sanguine views are
CLOs bundle together so-called leveraged loans, the hard to square with reality. The
subprime mortgages of the corporate world. These are Bank for International Settle-
loans made to companies that have maxed out their ments estimates that, across
borrowing and can no longer sell bonds directly to the globe, banks held at least
investors or qualify for a traditional bank loan. There $250 billion worth of CLOs at
are more than $1 trillion worth of leveraged loans cur- the end of 2018. Last July, one
rently outstanding. The majority are held in CLOs. month after Powell declared
I was part of the group that structured and sold in a press conference that “the
CDOs and CLOs at Morgan Stanley in the 1990s. risk isn’t in the banks,” two
The two securities are remarkably alike. Like a CDO, economists from the Fed-
a CLO has multiple layers, which are sold separately. eral Reserve reported that
The bottom layer is the riskiest, the top the safest. If just U.S. depository institutions
a few of the loans in a CLO default, the bottom layer and their holding companies
will suffer a loss and the other layers will remain safe. owned more than $110 billion
If the defaults increase, the bottom layer will lose even worth of CLOs issued out of
more, and the pain will start to work its way up the lay- the Cayman Islands alone. A
ers. The top layer, however, remains protected: It loses more complete picture is hard
money only after the lower layers have been wiped out. to come by, in part because
Unless you work in finance, you probably haven’t banks have been inconsistent
heard of CLOs, but according to many estimates, the about reporting their CLO
CLO market is bigger than the subprime-mortgage holdings. The Financial Sta-
CDO market was in its heyday. The Bank for Inter- bility Board, which monitors
national Settlements, which helps central banks pur- the global financial system,
sue financial stability, has estimated the overall size of warned in December that

42 JULY/AUGUST 2020
 14 percent of CLOs—more
than $100 billion worth—are
unaccounted for. CLOs: An Illustrated Guide
I have a checking account
and a home mortgage with
Wells Fargo; I decided to see
how heavily invested my bank Here is a hypothetical CLO from
is in CLOs. I had to dig deep before the coronavirus hit. Each of
into the footnotes of the bank’s the small boxes represents a lever-
most recent annual report, all aged loan, color-coded by rating. The
the way to page 144. Listed lower layers of the CLO are the riski-
there are its “available for sale” aaa est. The AAA layer is protected by the
accounts. These are investments layer lower layers.
a bank plans to sell at some lower
layers
point, though not necessarily
right away. The list contains
the categories of safe assets you
might expect: U.S. Treasury Illustrated here is how our hypo-
bonds, municipal bonds, and so thetical CLO might have performed
on. Nestled among them is an during the previous financial crisis.
item called “collateralized loan Many loans defaulted, but the defaults
and other obligations”—CLOs. were limited to the lower layers.
I ran my finger across the page
to see the total for these invest-
ments, investments that Powell
and Mnuchin have asserted are
“outside the banking system.”
The total is $29.7 billion. It
is a massive number. And it is A hypothetical CLO in April 2020.
inside the bank. Many loans have been downgraded
by the rating agencies, and defaults
are increasing.
Since 2008, banks have kept
more capital on hand to protect
against a downturn, and their
balance sheets are less leveraged
now than they were in 2007.
And not every bank has loaded
BASED ON DATA FROM FITCH RATINGS. THE FOURTH CLO DEPICTS AN

up on CLOs. But in December,

the Financial Stability Board The worst-case scenario. If the present
AGGREGATE LEVERAGED- LOAN DEFAULT RATE OF 78 PERCENT.

estimated that, for the 30 economic conditions persist or worsen,

“global systemically important widespread defaults could hit not just
banks,” the average exposure to the lower layers of CLOs, but the AAA
leveraged loans and CLOs was layer as well.
roughly 60 percent of capital
on hand. Citigroup reported
$20 billion worth of CLOs
as of March 31; JPMorgan
Chase reported $35 billion
(along with an unrealized loss
on CLOs of $2 billion). A cou-
ple of midsize banks—Banc of
bbb bb b ccc or lower defaulted
California, Stifel Financial—
have CLOs totaling more than
100 percent of their capital.

43
If the leveraged-loan mar- to the rating agencies’ defini- and their default correlation.
ket imploded, their liabilities tions, a B-rated borrower’s Even during a recession, dif-
could quickly become greater ability to repay a loan is likely ferent sectors of the economy,
than their assets. to be impaired in adverse busi- such as entertainment, health
How can these banks jus- ness or economic conditions. care, and retail, don’t neces-
tify gambling so much money In other words, two-thirds sarily move in lockstep. In
on what looks like such a risky of those leveraged loans are theory, CLOs are constructed
bet? Defenders of CLOs say likely to lose money in eco- in such a way as to minimize
they aren’t, in fact, a gamble— nomic conditions like the ones the chances that all of the loans
on the contrary, they are as sure Loan defaults we’re presently experiencing. will be affected by a single event
a thing as you can hope for. According to Fitch, 15 percent or chain of events. The rating
That’s because the banks mostly are already of companies with leveraged agencies award high ratings to
own the least risky, top layer of loans are rated lower still, at those layers that seem suffi-
CLOs. Since the mid-1990s, happening. CCC or below. These borrow- ciently diversified across indus-
the highest annual default rate
on leveraged loans was about
There were ers are on the cusp of default.
So while the banks restrict
try and geography.
Banks do not publicly
10 percent, during the previous more in April their CLO investments mostly report which CLOs they hold,
financial crisis. If 10 percent of to AAA-rated layers, what they so we can’t know precisely
a CLO’s loans default, the bot- than ever really own is exposure to tens which leveraged loans a given
tom layers will suffer, but if you of billions of dollars of high- institution might be exposed to.
own the top layer, you might before. It will risk debt. In those highly rated But all you have to do is look
not even notice. Three times
as many loans could default
only get worse CLOs, you won’t find a single
loan rated AAA, AA, or even A.
at a list of leveraged borrowers
to see the potential for trouble.
and you’d still be protected, from here. How can the credit-rating Among the dozens of com-
because the lower layers would agencies get away with this? panies Fitch added to its list
bear the loss. The securities are The answer is “default cor- of “loans of concern” in April
structured such that investors relation,” a measure of the were AMC Entertainment,
with a high tolerance for risk, likelihood of loans defaulting Bob’s Discount Furniture,
like hedge funds and private- at the same time. The main California Pizza Kitchen, the
equity firms, buy the bottom reason CLOs have been so Container Store, Lands’ End,
layers hoping to win the lottery. safe is the same reason CDOs Men’s Wearhouse, and Party
The big banks settle for smaller seemed safe before 2008. Back City. These are all companies
returns and the security of the then, the under lying loans hard hit by the sort of belt-
top layer. As of this writing, no were risky too, and every- tightening that accompanies a
AAA-rated layer of a CLO has one knew that some of them conventional downturn.
ever lost principal. would default. But it seemed We are not in the midst of
But that AAA rating is unlikely that many of them a conventional downturn. The
deceiving. The credit-rating would default at the same two companies with the largest
agencies grade CLOs and their time. The loans were spread amount of outstanding debt
underlying debt separately. across the entire country and on Fitch’s April list were Envi-
You might assume that a CLO among many lenders. Real- sion Healthcare, a medical-
must contain AAA debt if its estate markets were thought staffing company that, among
top layer is rated AAA. Far from to be local, not national, and other things, helps hospitals
it. Remember: CLOs are made the factors that typically lead administer emergency-room
up of loans to businesses that people to default on their care, and Intelsat, which
are already in trouble. home loans—job loss, divorce, provides satellite broadband
So what sort of debt do poor health—don’t all move in access. Also added to the list
you find in a CLO? Fitch the same direction at the same was Hoffmaster, which makes
Ratings has estimated that as time. Then housing prices fell products used by restaurants
of April, more than 67 per- 30 percent across the board to package food for takeout.
cent of the 1,745 borrowers and defaults skyrocketed. Companies you might have
in its leveraged-loan database For CLOs, the rating agen- expected to weather the pres-
had a B rating. That might cies determine the grades of the ent economic storm are among
not sound bad, but B-rated various layers by assessing both those suffering most acutely as
debt is lousy debt. According the risks of the leveraged loans consumers not only tighten

44 JULY/AUGUST 2020
their belts, but also redefine the dip, which it flipped for a buckle under the weight of new filings. (During a two-week
what they consider necessary. $100 million profit when prices period in May, J.Crew, Neiman Marcus, and J. C. Penney all
Even before the pandemic bounced back. Other banks, filed for bankruptcy.) We already know that a significant major-
struck, the credit-rating agen- including Bank of America, ity of the loans in CLOs have weak covenants that offer investors
cies may have been under- reportedly bought lower lay- only minimal legal protection; in industry parlance, they are
estimating how vulnerable ers of CLOs in May for about “cov lite.” The holders of leveraged loans will thus be fortunate
unrelated industries could be 20 cents on the dollar. to get pennies on the dollar as companies default—nothing close
to the same economic forces. Meanwhile, loan defaults to the 70 cents that has been standard in the past.
A 2017 article by John Griffin, are already happening. There As the banks begin to feel the pain of these defaults, the public
of the University of Texas, and were more in April than ever will learn that they were hardly the only institutions to bet big
Jordan Nickerson, of Boston before. Several experts told on CLOs. The insurance giant AIG—which had massive invest-
College, demonstrated that the me they expect more record- ments in CDOs in 2008—is now exposed to more than $9 bil-
default-correlation assumptions breaking months this sum- lion in CLOs. U.S. life-insurance companies as a group in 2018
used to create a group of 136 mer. It will only get worse had an estimated one-fifth of their capital tied up in these same
CLOs should have been three from there. instruments. Pension funds, mutual funds, and exchange-traded
to four times higher than they funds (popular among retail investors) are also heavily invested
were, and the miscalculations in leveraged loans and CLOs.
resulted in much higher ratings If leveraged-loan The banks themselves may reveal that their CLO investments
than were warranted. “I’ve been defaults continue, how badly are larger than was previously understood. In fact, we’re already
concerned about AAA CLOs could they damage the larger seeing this happen. On May 5, Wells Fargo disclosed $7.7 billion
failing in the next crisis for sev- economy? What, precisely, is worth of CLOs in a different corner of its balance sheet than the
eral years,” Griffin told me in the worst-case scenario? $29.7 billion I’d found in its annual report. As defaults pile up,
May. “This crisis is more hor- For the moment, the finan- the Mnuchin-Powell view that leveraged loans can’t harm the
rifying than I anticipated.” cial system seems relatively financial system will be exposed as wishful thinking.
Under current conditions, stable. Banks can still pay their Thus far, I’ve focused on CLOs because they are the most
the outlook for leveraged debts and pass their regulatory troubling assets held by the banks. But they are also emblematic
loans in a range of industries capital tests. But recall that the of other complex and artificial products that banks have stashed
is truly grim. Companies such previous crash took more than on—and off—their balance sheets. Later this year, banks may
as AMC (nearly $2 billion of a year to unfold. The present very well report quarterly losses that are much worse than antici-
debt spread across 224 CLOs) is analogous not to the fall of pated. The details will include a dizzying array of transactions
and Party City ($719 million 2008, when the U.S. was in that will recall not only the housing crisis, but the Enron scandal
of debt in 183 CLOs) were full-blown crisis, but to the of the early 2000s. Remember all those subsidiaries Enron cre-
in dire straits before social summer of 2007, when some ated (many of them infamously named after Star Wars charac-
distancing. Now movie- securities were going under- ters) to keep risky bets off the energy firm’s financial statements?
going and party-throwing are water but no one yet knew The big banks use similar structures, called “variable interest
paused indefinitely—and may what the upshot would be. entities”—companies established largely to hold off-the-books
never come back to their pre- What I’m about to describe
pandemic levels. is necessarily speculative, but it
The prices of AAA-rated is rooted in the experience of
CLO layers tumbled in March, the previous crash and in what
before the Federal Reserve we know about current bank
announced that its additional holdings. The purpose of lay-
$2.3 trillion of lending would ing out this worst-case scenario
include loans to CLOs. (The isn’t to say that it will necessar-
program is controversial: Is the ily come to pass. The purpose
Fed really willing to prop up is to show that it could. That
CLOs when so many previ- alone should scare us all—and
ously healthy small businesses inform the way we think about
are struggling to pay their the next year and beyond.
debts? As of mid-May, no such L a t e r t h i s s u m m e r,
loans had been made.) Far from leveraged-loan defaults will
scaring off the big banks, the increase significantly as the
tumble inspired several of them economic effects of the pan-
to buy low: Citigroup acquired demic fully register. Bank-
$2 billion of AAA CLOs during ruptcy courts will very likely

45
 question whether the Federal beg Nancy Pelosi for her help
Reserve has the authority to sparing the system. He under-
buy risky investments to prop stood the alternative.
up the financial sector, as it did It is a distasteful fact that
in 2008. (Dodd-Frank limited the present situation is so dire
the Fed’s ability to target spe- in part because the banks fell
cific companies, and precluded right back into bad behavior
loans to failing or insolvent after the last crash—taking
institutions.) Government offi- too many risks, hiding debt in
cials will hold frantic meetings, complex instruments and off-
but to no avail. The faltering balance-sheet entities, and gen-
bank will fail, with others lined erally exploiting loopholes in
up behind it. laws intended to rein in their
And then, sometime in the greed. Sparing them for a sec-
next year, we will all stare into ond time this century will be
the financial abyss. At that that much harder.
point, we will be well beyond If we muster the political
the scope of the previous reces- will to do so—or if we avert
sion, and we will have either the worst possible outcomes
exhausted the remedies that in this precarious time—it
spared the system last time or will be imperative for the U.S.
positions. Wells Fargo has more than $1 trillion of VIE assets, found that they won’t work government to impose reforms
about which we currently know very little, because reporting this time around. What then? stringent enough to head off
requirements are opaque. But one popular investment held in the next crisis. We’ve seen how
VIEs are securities backed by commercial mortgages, such as banks respond to stern repri-
loans to shopping malls and office parks—two categories of U n t i l r e c e n t ly, at least, mands and modest reform.
borrowers experiencing severe strain as a result of the pandemic. the U.S. was rightly focused on This time, regulators might
The early losses from CLOs will not on their own erase the finding ways to emerge from need to dismantle the system
capital reserves required by Dodd-Frank. And some of the most the coronavirus pandemic that as we know it. Banks should
irresponsible gambles from the last crisis—the speculative deriva- prioritize the health of Ameri- play a much simpler role in the
tives and credit-default swaps you may remember reading about can citizens. And economic new economy, making lending
in 2008—are less common today, experts told me. But the losses health cannot be restored until decisions themselves instead of
from CLOs, combined with losses from other troubled assets people feel safe going about farming them out to credit-
like those commercial-mortgage-backed securities, will lead to their daily business. But health rating agencies. They should
serious deficiencies in capital. Meanwhile, the same economic risks and economic risks must steer clear of whatever new-
forces buffeting CLOs will hit other parts of the banks’ balance be considered together. In cal- fangled security might replace
sheets hard; as the recession drags on, their traditional sources of culating the risks of reopening the CLO. To prevent another
revenue will also dry up. For some, the erosion of capital could the economy, we must under- crisis, we also need far more
approach the levels Lehman Brothers and Citigroup suffered stand the true costs of remain- transparency, so we can see
in 2008. Banks with insufficient cash reserves will be forced to ing closed. At some point, they when banks give in to temp-
sell assets into a dour market, and the proceeds will be dismal. will become more than the tation. A bank shouldn’t be
The prices of leveraged loans, and by extension CLOs, will country can bear. able to keep $1 trillion worth
spiral downward. The financial sector isn’t of assets off its books.
You can perhaps guess much of the rest: At some point, rumors like other sectors. If it fails, If we do manage to make
will circulate that one major bank is near collapse. Overnight fundamental aspects of mod- it through the next year with-
lending, which keeps the American economy running, will seize ern life could fail with it. We out waking up to a collapse, we
up. The Federal Reserve will try to arrange a bank bailout. All of could lose the ability to get must find ways to prevent the
that happened last time, too. loans to buy a house or a car, big banks from going all in on
But this time, the bailout proposal will likely face stiffer oppo- or to pay for college. Without bets they can’t afford to lose.
sition, from both parties. Since 2008, populists on the left and reliable credit, many Ameri- Their luck—and ours—will at
the right in American politics have grown suspicious of hand- cans might struggle to pay for some point run out.
outs to the big banks. Already irate that banks were inadequately their daily needs. This is why,
punished for their malfeasance leading up to the last crash, crit- in 2008, then–Treasury Secre-
ics will be outraged to learn that they so egregiously flouted the tary Henry Paulson went so far Frank Partnoy is a law professor
spirit of the post-2008 reforms. Some members of Congress will as to get down on one knee to at UC Berkeley.

46 JULY/AUGUST 2020
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