Expert Perspective

　　

Tension continues to increase. Financial experts bought billions of dollars in high-risk loans and repackaged them into complex investment products with multiple levels of debt. Credit rating agencies rated the highest-level debt as AAA. Institutional investors, including pension funds and charitable organizations, are racing to buy these seemingly risk-free but high-yielding investment products. But this is not the situation in 2006 or 2007, but now.

    Although the US government talks about repealing the Dodd-Frank Act, the reality is that regulators have ignored the law for years, and now the shadow financial market is in a bubble. Nearly ten years after the outbreak of the global financial crisis, the sequel is here.

    The culprit this time is the "collateralised loan obligation" (CLO). Like earlier products that are difficult to understand, CLO packages high-risk, low-rated loans into attractive and high-rated investment products. In May of this year, there were two CLO issuances, each of which exceeded US$1 billion. Experts estimate that there will be US$75 billion worth of CLO issuances this year. Antares Capital recently completed a $2.1 billion CLO issuance, which is the largest CLO transaction in the United States since 2006 and the third largest in history. Although most of the loans in these agreements are "junk" grades, more than half of the new bonds are AAA rated. Sounds familiar, right?

    At the beginning of this century, similar high-rated products called "collateralised debt obligation" (CBO) were very popular. At first, they did not seem to be harmful, or at least not so harmful that their crash could spread to the entire financial industry. But when regulators ignore their growth, they are becoming increasingly opaque, and their profits are getting higher and higher, and their credit ratings are out of touch with reality. As with cracks in the foundation of a house, these risks initially seem to be small. But the high rating conceals the instability of the entire structure. Until the end it was too late.

    The Dodd-Frank Act was expected to prevent these credit rating tricks. But the US Securities and Exchange Commission (SEC) allows these agencies to circumvent the law. Although the Dodd-Frank Act would make these institutions liable for incorrect ratings, the SEC exempted them from liability. Similarly, Congress prohibits these agencies from obtaining inside information about the issuers they rate, but the SEC also allows them to do so. With the development of CLO, the cracks spread again.

    On the eve of Christmas last year, the so-called risk retention rules of the Dodd-Frank Act came into effect, requiring the organizers of these complex agreements to bear some of the risks. But smart financiers arrange for a third party to bear this risk.

    Credit rating agencies, especially Moody's Investors Service and S&P Global Ratings, are the protagonists of this story, just like the original financial crisis. The computer programs they use to rate AAA ratings still have flaws. Because loan defaults may be swarming, the mathematical model should consider "associated risks", that is, the possibility of simultaneous outbreaks of defaults. But the CLO model assumes that the associated risk is very low. When defaults occur at the same time, these so-called AAA investment products will lose their money. CLO just changed the packaged CDO.

    Some experts say that this time is different. Earlier in July, Ashish Shah, the managing director of Madison Capital Funding, a subsidiary of New York Life, told a group of CLO experts that they were in 2017 Don’t worry about default. He said: "People's desire for assets is very strong." Pension funds, insurance companies and university endowments require both security and high returns. CLO seems to meet these two requirements.

    A newly established credit rating office within the SEC should have guarded this desire. But when I sent a letter of inquiry under the Freedom of Information Act to find out which credit rating agencies were found to have violated SEC regulations, the regulator refused to disclose their names. Violators still haven't been made public.

    Financial markets are difficult to manage. New graduates of business schools are bound to be one step ahead of newcomers to regulators. Many of the least credible companies find it easy to borrow money because their loans can be quickly repackaged and sold. In the debate about whether the Dodd-Frank Act will be repealed or not, legislators should pay close attention to these complex investment products and the institutions that promote these investment products.

    Some people may claim that the CLO is different, or that it is smaller, or that regulators are now more prepared, or that corporate loans cannot be defaulted at the same time as mortgage loans. But at the beginning of this century, similar views existed before the risk spread to big banks and American International Group (AIG), and the market gradually got out of control.

    In order to avoid the advent of a greater crisis, regulators should pay attention to signs of financial market failure and hidden risks before cracks spread.