Trump is not good for the U.S. economy.

The junk debt that tanked the economy? It's back in a big way.

Like most people, you probably assume that the level of lending done by banks at any moment is largely driven by how much demand there is from borrowers. But in the world of modern finance, that’s only part of the story. For just as important is the level of demand from investors — pension funds, hedge funds, mutual funds, sovereign wealth funds and insurance companies — to buy the loans that banks make. Indeed, there are times when there’s so much demand for loans from investors and the profit from selling them is so lucrative that bankers are only too happy to go out and make bigger and riskier loans than they would if they were keeping them on their own books.

Now it is happening again, as investors and money managers scramble to buy floating-rate debt — debt offering interest payments that will increase as global interest rates rise, as they are expected to over the next few years. A big new source of floating-rate credit is the market for “leveraged loans” — loans to highly indebted businesses — that are packaged into securities known as “collateralized loan obligations,” or CLOs. Because the market seems to have an insatiable appetite for CLOs, leveraged lending and CLO issuance through the first half of the year are already up 38 percent over last year’s near-record levels.

Credit-rating companies such as Standard & Poor’s and Moody’s have recently warned that this surge in corporate borrowing and lending has led to a noticeable decline in the quality of the loans. The borrowers have lower credit ratings. The loans contain fewer of the standard conditions that are meant to protect lenders. And the rating companies calculate that lenders should expect to recover less of their money if the borrowers default or go into bankruptcy.

For the most part, however, these warnings have gone unheeded. Although some sophisticated investors have begun to pull back from the CLO market, they have been replaced by retail investors seeking higher yields who have flocked to mutual funds and exchange-traded funds that specialize in CLO debt.

Earlier this year, after complaints from banks and dealmakers reached sympathetic ears in the Trump administration, the newly installed chairman of the Federal Reserve and the Comptroller of the Currency Office declared that previous “guidance” against lending to companies whose debt exceeded six times their annual cash flow should not be taken as a hard and fast rule.

Regulators later explained that the announcement was not meant to lower lending standards but rather to emphasize that multiple factors would be used by bank examiners in assessing loans. More broadly, their view is that because banks are now so much better capitalized, with less leveraged and less reliance on short-term funding, they will be able to survive a serious market correction, as demonstrated by recent “stress tests” in which their exposure to leveraged loans was factored in.

Whether intended or not, however, the market read the regulators’ announcement not only as a green light to the banks to step up their leveraged lending but also as an indication that regulators would be more responsive to industry pressure than during the Obama years.

The CLO market got an even bigger boost this year when an appeals court in Washington struck down a regulation issued under the Dodd-Frank financial regulation law that required all securitizers — the firms that bundle loans of any kind and sell pieces of the packages to investors — to retain 5 percent of a deal. The regulation’s rationale was that if the securitizers had “skin in the game,” they wouldn’t have an incentive to make or buy questionable loans and peddle them to unsuspecting investors. For Dodd-Frank’s authors, this was a central feature of the architecture of financial reform.

When the risk retention rules were finally announced, however, the association representing independent CLO managers — those not associated with big banks — sued to block it, arguing the law did not apply to them because they never take ownership of the loans, so there is nothing for them to “retain.” Instead, these managers raise money from investors through an independent, legal entity known as a special purpose vehicle and then direct the SPV to use that money to buy the loans on the open market. A district judge saw through the ruse and dismissed the suit, but in February, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit bought the industry argument hook, line and sinker.

The appeals court opinion is a model of legal and etymological hairsplitting by activist, conservative judges who were clearly looking for a way to ignore the explicit intent of Congress, which was to make risk retention a feature of all loan-backed securities, no matter who made the original loan.

In fact, the CLO managers had asked the House Financial Services Committee to include a specific exemption for them in the law, citing the financial burden it would place on smaller securitizers. They also argued that the standard CLO fee structure, which provided bonus payments if investors were paid in full, was the equivalent of their having “skin in the game.”

The legislators, however, were not receptive to those arguments.
“The basic idea was to cover all securitizations, so we used very broad language,” Lawranne Stewart, then assistant chief counsel to the committee, recalled. “In fact, the language in the bill generally was so broad that we were criticized for overreaching. . . . We told [the CLO managers] that we would leave it to the regulators to deal with the question of who did and did not deserve an exception.”

Regulators, however, were also reluctant to create an exception. As they warned the appeals court in their briefs, if independent CLO managers were exempted from risk retention, it would create a giant loophole for any managers using the same method and structure to securitize any type of loans. Those who didn’t would be at a serious competitive disadvantage.
Although none of the three judges had spent a day working on Wall Street, they nonetheless dismissed the warnings of agency experts and in their opinion “provided a road map for securitizers of all sorts to avoid risk retention,” according to Michael Barr, a professor of law and public policy at the University of Michigan who served as point man on the financial reform effort for the Treasury in the Obama administration. As a result, Barr said, we “have now re-created the condition that led to the last crisis by making it easier to aggregate loans that are not good for investors.”

The three judges who signed on to that opinion were all appointed by Republican presidents, all have a long track record of skepticism toward regulation and regulators, and all have a long association with the conservative Federalist Society. Only one of them, however — Brett M. Kavanaugh — was just nominated by President Trump to be a Supreme Court justice.

Fritz, rather an alarmist article and somewhat typical for msn. CLO’s aren’t anywhere close to being the danger that article would have us believe.