So why would a pension be involved with a CLO? The simple answer is this: since the underlying loans are riskier, they pay higher interest and, in a market where returns for equities over the next 10 years are expected to be lower than they have been over the previous 10 years CLOs are sold as a way of getting a higher return with the illusion of not taking on additional risk.
All securitized debt is divided into different types of shares known as tranches. There is a senior tranche which is the least risky, because they get paid first, but they also receive a lower share of the interest payments and hence get a lower rate of return. There is a mezzanine tranche in the middle which is riskier but they earn a higher rate of return. Finally, there is a junior tranche which gets what is left after the other two tranches are paid off.
Despite the fact that the underlying securities are speculative, the structure allows the debt held by those in the Senior tranche to be given a AAA rating, thus creating what appears to be a “free lunch.” That is, those purchasing CLOs in the senior tranche get higher interest rates than those generated by other (legitimately rated) AAA debt. The reason for the low risk rating is because before anyone in the senior tranche would lose money, the investments in the mezzanine and junior tranches would have to be wiped out. So, why would anyone ever invest in the junior tranche? The answer is they get equity level returns without the volatility of equities.
Perhaps the easiest way to understand collateralized debt is to look at a collateralized mortgage obligation (CMO). Banks make loans so people can buy houses. Rather than holding those loans on their books, banks sell them to an investment bank which bundles them together and sells the bundle as a security which is divided into shares and sold on the market. The loans are overcollateralized because when you buy a house you have to make a down payment. If you default, you lose your down payment, and even if the bank sells the house for somewhat less than you paid for the house, it can likely still get back the money it lent to you.
For example, suppose you buy a house for $200,000, you put down 10% ($20,000) and get a mortgage for $180,000. The house is the collateral, and it is worth more than the loan. Now imagine a lender does this 1,000 times and thus has loaned out $180 million. Assume the interest rate on the loans is 6%, and the loans are for 30 years. Now suppose the lender divides the $180 million bundle into 1,000 shares and sells each share for $180,00. The share-holder would receive a payment of about $1,079.19 per month for 30 years, assuming there are no defaults. After 30 years, the share-holder would get back the principal of $180,000 and $208,508.74 in interest to boot. But suppose there is a 10% default rate, i.e., 100 of the 1,000 mortgage-holders make no payments at all. Then, instead of getting $1,079.19 per month for 30 years, the share-holder gets $971.27. So, over 30 years, the share-holder would get $162,000 in principal payments and $187,657.87 in interest payments. If the house is s4ll worth $200,000, the lender forecloses, and then sells the house, incurring $20,000 expenses, the lender nets $180,000 — the same as the money the lender originally loaned out, but less money than you than what you would have received had no one defaulted. If the price of the house goes down to $150,000, then not only has the lender lost due to the default, but also an additional $30,000 when the house was sold.
So, CLOs are subject to the risks (defaults, falling market prices) in the above example, and other risks as well. To mitigate against these risks, the lender can buy insurance called a credit default swap (CDS). Of course, appropriate pricing of a CDS depends on the insurer having a correct understanding of the risks being insured against. If the insurer underestimates the risk, then the insurer may not be able to cover the losses; that is exactly what happened in the second of the two bubbles we describe in the following paragraph.
All of these complex arrangements are subject to systemic risks. These are illustrated by two “bubbles”. Think first of the .com bubble, when from 2000-2002 the NASDAQ lost 75% of its value and did not recover for 15 years. Think also of the housing bubble 2007-2008, when the S & P 500 dropped 57% and took 5 years to recover -- even after a massive federal bailout plus the Fed also dropping interest rates to zero and engaging in quantitative easing. In that case, credit default swaps were already on the scene. So, within the space of a decade, financial markets experienced two major financial crises.
No one can predict when the next financial crisis will occur. But the growing complexity of our financial system, including the explosive growth of private equity and private credit, should give pause to those of us whose re4rement is totally dependent on the performance of financial markets; we should be wary when our pension systems participate in structured debt (that is, in the structured loan market).
One obvious solution, which would allow STRS to take less risk and continue to provide a secure retirement to Ohio’s teachers, would be to have a variable employer contribution like almost every other public pension in the U.S. (outside of Ohio). That would reduce the risk the pension needs to take and enable it to pay a COLA to retirees and provide an unreduced pension for active teachers after 32 years.
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