The coronavirus pandemic could end up sparking a financial crisis bigger and more serious than 2008, UC Berkeley School of Law Professor Frank Partnoy warned. He said, like the sub-prime mortgage-backed securities (CDOs) that sparked the Great Recession, growing issues are building in the financial sector. He issued an alert over CLOs (Collateralised Loan Obligations), bundles of business loans generally made to smaller sized companies, some of whom don’t qualify for traditional bank loans or have other issues.
Professor Partnoy said: “Back in 2007/8, CLOs weren’t risky, we weren’t worried about these businesses all defaulting simultaneously.
“Right now, in the pandemic, we have a lot of businesses that are in trouble and very likely to default, so now CLOs are more dangerous than CDOs.
“There’s certainly more than $ 100 billion of CLOs at banks. We also know that there about about $ 100 billion of CLOs that are unaccounted for, we can’t find them.
“We’re getting lots of surprises on CLOs. JP Morgan announced that it had lost $ 2 billion, and basically nobody even noticed that it had happened.”
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‘Back in 2007/8, CLOs weren’t risky, we weren’t worried.’
He told CNBC: “These are big numbers, but they’re not the kind of numbers that would bring a bank down on their own.
“However they are numbers that should cause us concern when coupled with other kinds of losses banks are inevitably going to have in the next quarter and beyond this year.”
Professor Partnoy also confirmed that CLOs were built very similarly to CDOs, in that the underlying loans are risky.
He said when they are packaged, the top part of the CLO should be low risk, in the same way as the CDO in 2007.
Professor Partnoy also confirmed that CLOs were built very similarly to CDOs.
But the law expert continued: “The problem is if a lot of these loans all default at the same time, the way sub-prime mortgages all defaulted at the same time, then even those top layers that are rated highly can become at risk.
“In late March, we know that the triple A layers were seriously at risk, and there were major concerns about the pricing of those layers.
“Many people are worried that the losses that are increasing in the future will start to eat into those triple A and double A layers.”
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However, he did say there was one silver lining which could yet mitigate the scale of the economic disaster.
Professor Partnoy explained the reason the 2008 financial crash was so bad was because nobody really saw it coming, and therefore did not act in time to save those mortgages that went bad.
Twelve years later, there are a lot of federal programmes to prevent the same situation occurring again.
Professor Partnoy said: “Certainly the Fed has been very quick, and they’ve learned to really impact the psychology of markets.
“Also they’ve said they’re going to start examining banks a lot more.”