Big Banks Again

Frank Partnoy a law professor at UC Berkley has a disturbing article in the Atlantic Magazine called the Looming Bank Collapse. The article is worth reading. Partnoy reminds us that the underly cause of the 2009 Global Financial Crisis (GFC) was default on home mortgage debt. Big banks had sliced and diced mortgages into collateralised debt obligations (CDOs) that were sold on to a variety of financial institutions.

At the time, the experts at the US Treasury and the Federal Reserve claimed that this strengthened the financial system because the risk was carried by those organisations that could afford to carry it. Of course, that claim proved to be a joke. The risk had been chopped up and shifted around so much that no one no who was carrying it, and in the end, taxpayers found themselves carrying most of the risk.

Frank Partnoy suggests that a similar situation has emerged with collateralised corporate. The big banks have been slicing and dicing some fairly dodgy corporate debt into Collateralised Loan Obligation (CLOs) with the same techniques that they used for house mortgages. The value of outstanding corporate debt CLOs is now greater than mortgage-based CDOs prior to the GFC. The experts say that this is good because the risk has been shifted around and is now held by financial institutions that are best placed to carry it. We have heard that one before.

The other so-called advantage of CLOs is what the insiders call “default correlation”. They rely on avoiding it The idea is that even during a recession, different industries and regions will perform better than others. The CLOs are supposedly constructed in a way that should spread the regional and industry coverage to ensure that a negative event will only affect some of the loans. Remember when they used to say that the house prices have never fallen right across the United States at the same time. Same story.

Default correlation might be a useful tool in normal times when even if some businesses are struggling, others will be prospering. Unfortunately, that does not apply during a global pandemic when businesses in most regions and sectors are badly affected, so we will soon see how bad default correlation can bite.

I am not sure how serious this problem is, but it sounds ugly. Frank Partnoy ends his article with a dire warning for the big banks.

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.

And the ordinary taxpayer will pay the price.