Collateralized Loan Obligations Are Riskier Than Most Realize – Bloomberg
Japanese banks, which have bought up to 75 percent of AAA CLO tranches and perhaps one-third of all CLOs, finance their holdings by borrowing dollars and euros in the inter-bank markets. Losses may create difficulties in rolling over funding, leading to a liquidity squeeze. As in 2008, that would accelerate declines in prices.
As we saw last December, problems with CLOs may result in a contraction of credit. CLOs purchase 50-60 percent of all leveraged loans, just as CDOs funneled funds into mortgages. The demand from CLOs has underpinned decreases in the price of credit and looser lending terms.
In the case of a downturn, the risk is that CLOs will create adverse feedback loops. Banks will be stuck with unsold inventories of underwritten loans. Falling prices, rising spreads and tightening credit availability will cause credit markets to seize up. Tighter credit will feed into the real economy, setting off losses, selling and price declines. Fears about the financial position of banks and investors will create contagion as depositors refuse to fund banks and investors demand their money back.