CLOs — their AAA Credit Rating is based on “default correlation” — the Odds of All Loans Defaulting at the Same Time
The odds of all the loans defaulting at the same time are about the same as a “black swan” event.
How about three of them, you know, at the same time?
Welcome to 2020:
A pandemic, a ‘slow the spread’ recession, and mass demonstrations and property destruction in the inner-cities.
Add a fourth black swan event? This one, as described in the Atlantic, a coming Collateralized Loan Obligation — which are massive debt instruments used to loan capital to businesses in trouble, and that are recognized, at the time of the loan, to be sensitive to economic conditions. The fourth black swan event is that they all default at more or less the same time — over the next two quarters — due to universally bad economic conditions.
“How can the credit-rating agencies get away with this? The answer is “default correlation,” a measure of the likelihood of loans defaulting at the same time. The main reason CLOs have been so safe is the same reason CDOs seemed safe before 2008. Back then, the underlying loans were risky too, and everyone knew that some of them would default. But it seemed unlikely that many of them would default at the same time.”