Wall St.: Yup, They’re At It Again!

 By Shlomo Maital



 Frank Partnoy was a Wall St. insider who wrote two powerful books, showing how greed and deceit have corrupted our crucial financial markets, leading to the disastrous 2008 financial crash and ensuing economic crisis.

       Hard to believe but – he now reports (in the Financial Times) that the same skullduggery that sank the world in 2008 has begun anew, with slightly different disguises.

   The central culprit this time is the collateralised loan obligation. Like its earlier esoteric cousins, a CLO bundles risky low-grade loans into attractive packages and high credit ratings. In May, there were two deals of more than $1bn each, and experts estimate that $75bn worth are coming this year. Antares Capital recently closed a $2.1bn CLO, the largest in the US since 2006 and the third-largest in history. Although most of the loans underlying these deals are of “junk” status, more than half the new debt is rated triple A. Sound familiar?   During the early 2000s, similar highly rated deals called collateralised debt obligations were popular. At first, they seemed harmless, or at least not so big that their collapse could cause financial contagion. But when regulators ignored their growth, they became more opaque and more profitable, with credit ratings disconnected from reality. Like cracks in a building’s foundation, the risks seemed minor at first. But high ratings hid the instability of the entire structure. Until it was too late.

   Same script, different actors.   Hide junk bonds in a package with good bonds, and have the credit ratings agencies rate the whole package AAA, triple A, risk-free.

The credit rating agencies, particularly Moody’s Investors Service and S&P Global Ratings, are the central actors in this story, just as in the original. The computer programs they use to assign triple-A ratings remain flawed. Because loan defaults can come in waves, mathematical models should account for “correlation risk”, the chance that defaults might occur simultaneously. But the models for CLOs assume correlations are low. When defaults occur at the same time, these supposed triple-A investments will be wiped out. CLOs are just CDOs in new wrapping.

   Partnoy observes that keeping financial markets honest, clean and sane is really difficult!

It is hard to police the financial markets. New business school graduates are inevitably one step ahead of their regulator counterparts, and many of the least creditworthy businesses find it easy to borrow, because their loans can be quickly repackaged and sold. During the debates about Dodd-Frank repeal, legislators should keep their eyes on these complex investments and the agencies that facilitate them.

    Trump and his Treasury Secretary are actively working to repeal the key elements of Dodd-Frank, the legislation that keeps 2008 from recurring.

Fasten your seat belts!