Triple A-rated Wall St. junk, or another crash around the corner

You can’t blame bankers for trying to make money. That’s what defines them. But regulators are letting their guard down and Wall Street is back at peddling its old wine in a new bottle. Conditions are ripe for a perfect storm.

Now the villain lurking around the corner are collateralized loan obligations, or CLOs, tells us Frank Partnoy, writing for the Financial Times. Remember collateralized debt obligations, or CDO? There is no coincidence in the similarity of their names. They are cousins: they are repackaged junk. The underlying debt is high-yield, but the product the Street is selling is rated triple A.

If that sounds difficult, there is a simple metaphor. Imagine the trash at home. Each piece of it—the empty beer can, the banana peel, the used paper napkins—is worthless. But the bag is worth gold. Makes sense? Unless you are in the business of recycling garbage, for most people it would still be just that: a lot of trash. Well, the products bankers are repackaging there are bad debt, loans taken by risky borrowers, and the like.

The bad news is that $75 billion of this triple A rated garbage may be coming into the market this year. And just as regulators ignored the growing threat of the now forgotten CDOs and subprime mortgages, the cancerous cells are growing again.

Partnoy says that Moody’s Investors Service and S&P Global Ratings are using flawed computer programs to rate this debt. “Because loan defaults can come in waves, mathematical models should account for ‘correlation risk’, the chance that defaults might occur simultaneously,” he writes. However, these models are assuming correlations are low. “When defaults occur at the same time, these supposed triple-A investments will be wiped out.”

The grind of daily life erases memories quickly. But this writer remembers the blinking screens of Bloomberg terminals following the collapse of Lehman Brothers in 2008. The world, not just the U.S., came very, very close to a Great Depression on a massive scale. Only rapid intervention by the governments of major economies and global financial institutions including the IMF and the World Bank prevented a disaster from becoming a catastrophe. The Quantitative Easing and the bond-purchasing programs that still run to this day are part of the financial therapy needed to keep factories and companies working. Central banks are pumping money into the economy in the same way that doctors inject blood into a weak patient.

 

Yet this threat finds the world at a particularly difficult political juncture. The White House is in chaos. Other than the fun Saturday Night Live makes out of it to the joy of millions, what’s going on in Washington is no laughing matter. China and Russia are trying to fill the role the U.S. is giving up in world affairs, and that does not bode well for representative democracy. Britain is withdrawing back into the small confines of its island after the Brexit vote, and a xenophobic candidate like Marine Le Pen almost made it to the presidency of France on an anti-European Union ticket. That the U.S. government is now dismantling financial regulation too is cause for grave concern.