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Looking for the Next Crisis: the Not Very Scary World of CLOs

We’re still in financial crisis mania, as the business press eagerly tries to tell us how little they learned from the last crisis by trying to identify the source of the next one. The NYT’s latest contribution to the effort is a piece on C.L.O.s, or collateralized loan obligations.

The piece tells us that these are like the C.D.O.s of the last decade, debt instruments in which banks bundled many loans of questionable quality and sold them off to unsuspecting buyers. It warns that banks have little incentive to ensure their quality, since they don’t hold a stake, and therefore there is a risk of large-scale defaults.

There are two big problems with the scare story here. First, the growth in these risky instruments is not quite what the piece might have readers believe. The piece includes a chart which shows the amount of junk bonds and C.L.O.s outstanding since 2014. While the point of the chart is to show that volume C.L.O.s has passed the volume of outstanding junk bond debt, a more serious analysis would combine the two together to get a gage of the amount of high-risk corporate debt in the economy.

This combined measure does not tell much of a story. Eyeballing the chart, we go from a combined total of roughly $1.95 trillion in 2014 to $2.5 trillion in the middle of 2018. Since this is a period in which the economy has grown by roughly 20 percent in nominal terms, this indicates only a modest rise in the ratio of risky corporate debt to GDP. This is not the sort of stuff that need keep us awake at night.

But the more important point is that the 2008 crisis was caused by the collapse of a bubble that was driving the economy. This was easy to see for people familiar with Econ 101. Residential construction hit a record share of GDP far above its average in prior decades. Housing wealth lead to a consumption boom, with savings rates hitting record lows.

What is the component of GDP that is driven by loans in C.L.O.s? Investment is at very modest levels as a share of GDP. It’s hard to envision it falling very much if this market tanked tomorrow. Suppose the holders of this debt took a huge hit, losing 50 percent of their investment. That would be a loss of $650 billion in wealth, bad news for them, but hardly close to enough to sink an economy with $90 trillion. In fact, the impact would likely be trivial in terms of overall GDP growth.

In other words, for the folks looking for the next crisis, you’ll have to do better.