A review of Partnoy’s COVID Market Warnings

The 2007 and 2008 economic collapses culminated in a catastrophe now known as the great recession. Though both collapses were different in scale, it is impossible to ignore their significant impacts and correlation to one another as the economy crashed in the final months and years of the Bush Administration. Today, Americans and people around the world still face the repercussions of the irresponsibility of financial institutions and government officials of the mid-late 2000’s. Though many do not entirely understand the death spiral that the stock market took in 2008, it is simpler than the technical jargon utilized by industry experts suggests, and it will happen again. Where 2008 was defined by the Collateralized Debt Obligation (CDO), the of 2020 and the years to come will be crippled by the Collateralized Loan Obligation (CLO). The ratings of basic debt obligations are contingent upon the diversity of individually backed mortgage loans packaged as a bond, loan obligations, however, fall under a separate and more institutional groundwork. The 2008 collapse was based on banks’ issuance of bonds by diversifying subprime debts for individuals, the market today plays a similar game but hedges obligations on the ability of businesses to pay loans and maintain credit ratings regardless of verification, putting more of the economy at risk. In 2008, when the housing bubble first collapsed, the United States maintained an antiquated understanding of the housing market. The paradigm argued the economy was built on the back of the mortgage- the American housing market. That paradigm was based on a thirty year expectation that bonds would remain a stable range of securities, and investments on that traditional stability became an outsized portion of the American economy. In his 2020 piece for the Atlantic on the uncertainty of the market surrounding COVID19, Frank Partnoy explains the role of the consolidation and collateralization of the Mortgage Backed Security (MBS) market of the 2000’s. “CDOs were intended to shift risk away from banks,” Partnoy wrote, but “the same banks that issued home loans also bet heavily on CDOs,” indicating that the subprime market built a loop and making a traditionally regional market a national gamble (Partnoy). Partnoy provides a basic understanding of the multi-tranche CDO market, but mortgages were only part of the collapse. Realtors signed mortgages in the years leading up to the collapse. Where the mortgage bond market was conceived on the stability of a 30-year fixed rate mortgage, its conclusion was marked by the flexibility of an adjustable mortgage. As the supply of high tranche mortgage investments dried, the market for lower rated securities opened in search of diversified rather than risk-averse consolidated bonds. The adjustable loan would have a three-year ‘teaser rate,’ providing a figure that most high-risk recipients could pay until the initial rate expired for the market-adjusted rate. When the recipient’s rate changed, the mortgage would default as a result of delinquency. This is to say that America’s largest banks consolidated subprime debts with the expectation that mixed-tranche, high risk portfolios could not default at a rate that could damage the credit rating of the underlying bonds. These actions tied regional housing markets to the national economy. Moreover, the market was expanded further by the synthetic CDOs- trades which essentially hedged earnings on the success of a CDO composed of initial mortgage-based CDOs- which out-valued the initial securities trade. The CDO market in 2008 accounted for 640 billion dollars, though the total amount including synthetic investments are unknown as there was no regulatory standard for reporting synthetic trades and the banks did not want to telegraph their leverage against housing, shorting the market. By late 2007, the initial CDOs and the synthetics that they backed did the unthinkable and as the adjustable rates defaulted, the securities collapsed. Today’s economy is based on a similarly destructive investment known as a Collateralized Loan Obligation (CLO). This form of credit depends on business loans, large and small, and behaves in a similar manner to CDOs. The correlation indicates that America is in danger of repeating the 2008 collapse with 20% more capital on the line. Where the CDO market accounted for 640 billion dollars, the CLO market accounts for at least 880 billion at present. That figure does not include the range and value of synthetics but is catastrophic on its own as those loans are not simple mortgages. CLO’s are exponentially more destructive because the corporations and businesses receiving these loans are responsible for guaranteeing supply chains during the largest health crisis in a century. The Trump administration’s Fed chair and Treasury secretary have lauded CLOs much in the same way that Greenspan and Bernanke guaranteed the security of CDO trades, claiming that the investments are “outside the banking system,” though Partnoy paints a more ominous picture, explaining that Wells Fargo owns over 4% of the market for CLOs (Partnoy). Partnoy claims that the dangers are similar to 2008 and they are, particularly at Banc of California and Stifel, where investment in CLOs is valued at over 100% of assets and on-hand capital. Partnoy heeds warning at those who claim CLOs are safe investments; the same was said of similarly structured CDOs. If the investment is safe until defaults reach the irreversible rate of 8–15%, but investments are simply diversified amongst subprime recipients, the safety of those assets are inevitably threatened by even minor shifts to a market or in the loan obligation. The warning is particularly salient as the COVID-19 pandemic sinks small and medium-sized businesses, many of which depend on risk keen investments with little collateral. Partnoy’s fears were exacerbated earlier this year when the federal government distributed direct relief to more CLOs than stable small businesses as the United States implemented stay-at-home orders. The inability of the market to recognize effective targets of relief displays openly the preference for high returns rather than stability. Delaying mass-defaults in a period of economic turmoil maintains confidence in CLOs but does not change the underlying failure of subprime investments, catalyzing a potential bubble in the business lending market. Partnoy’s concerns over the present instability of the market are daunting for another reason; the opposition. Economic populism and the bipartisan shift toward distrust for the banks indicates that there will be no comprehensive bailout as there was in 2008 (Partnoy). As he wrote in his article, “The financial sector isn’t like other sectors. If it fails, fundamental aspects of modern life could fail with it,” meaning that without sustainable credit, common individual needs could go unmet (Partnoy). America’s unwillingness to either recover or regulate the market is a perilous prospect as Americans face record unemployment, evictions, and expenses. There is a paradigm shift and much of it will require Americans to accept moderate as opposed to overwhelming growth in the economy