Once Begun... Financial Innovation Continues To Thrive

Includes: IYF, WFC
by: John M. Mason


Collateralized Loan Obligations (CLOs) are increasing at pre-financial crises rates.

The drive for yield continues in this low interest rate environment.

Bankers are watching risk now, but concern is that they will continue to push into higher yields to earn margins.

Gretchen Morgenson devotes her whole column in the Sunday New York Times to the topic of Collateralized Loan Obligations," CLOs.

CLOs, she writes are "bundles of mostly commercial loans that are sold in various pieced to investors." They can, Morgenson continues, can contain bonds, equity interests or other assets.

CLOs are similar to Collateralized Debt Obligations, CDOs, an instrument that became notorious in the financial collapse of the late 2000s.

My point is that once financial innovation takes place, the instruments created seem to take on a life of their own.

I have noted just recently the return of the subprime loan -- this time particularly in subprime auto loans -- and by such a "conservative" commercial banks as Wells Fargo (NYSE:WFC).

In this article is the following quote, "Wells Fargo has become a leading player in the subprime auto market, where loans often carry high interest rates and are typically used to buy previously owned cars.

As of the end of 2013, Wells Fargo was the second-largest lender to used car buyers with credit scores below 620, was a market share of 10.3 percent, according to J. D. Power & Associates."

In earlier articles I have written about the return not only of CLOs but also the return of a lot of other twenty-first century financial innovations. The title of the post is "We have Seen A Return Of Practices That Made People Nervous In 2007." Here is my summary from the post:

"The issuance of "'triple C' rated bonds, the lowest possible designation, totaled $15.3 billion through June in 2013. Over the past ten years, the previous high is $11.3 billion in 2012. And, before that, only $10.6 billion of these CCC-rated bonds were issued in 2007, the previous high.

Collateralized loan obligations through November 2013 were at $75.9 billion, not too far below the peak level these issues reached in 2006 and 2007. 'Covenant-lite' bonds accounted for almost 60 percent of loans sold in 2013 compared with a 25 percent share in 2007…a total of almost $60 billion. 'Payment in kind' bonds…where borrowers have an option to repay lenders with more debt…were getting close to the 2008 total just through May 2013. Commercial mortgage-backed securities, although running far below the totals of 2005 through 2007, have now exceeded in 2013 the totals reached in 2004.

And, there almost seems to be a shortage of securities available to investors since the Federal Reserve has taken so many bonds off the market. Citigroup (NYSE:C) research that estimates the 'net' issuance of financial assets in 2013 to be about $1 trillion which is far fewer than the $3 trillion to $4 trillion sold in the years before the financial crisis.

As a consequence, the prospect is that more and more securitization will take place in 2014 and beyond."

And, Morgenson presents more current data. "Issuance of these instruments (CLOs), strong last year, is even stronger now. Through April 16, over $32 billion in CLOs have been issued this year, up from $29 billion during the same period last year, according to S&P Capital Insight's Leveraged Commentary & Data. In March issuance of CLOs was the highest in any month since 2007 and April is on track to being the biggest single month ever."

What is being issued now is said to be much less risky than the securities issued before 2009. Ms. Morgenson writes that there are $431 billion in CLOs that are currently outstanding…this according to the Securities Industry and Financial Markets Association. "Roughly $150 billion worth were issued before 2009. That group represents the riskiest securities in the asset class, regulators say. Another $150 billion in CLOs issued after 2009, contain fewer problematic assets; those remaining, raised after the pending Volcker Rule restrictions had been announced, are viewed by regulators as the least risky of all."

There is concern, however, about how these "tools" are getting back into the mainstream. Risk control might be well managed at this particular time, but you know, these bankers are constantly pushing the edge. Ms. Morgenson quotes a statement made this past week by Paul Volcker, the former Fed Chairman who first presented the idea behind the Volcker Rule, "This constant effort to get around the rule limiting banks' investment in hedge funds, on behalf of a few institutions who apparently want room to resume the financial practices that got us into trouble in the past really should end."

But, they won't end.

As I wrote in another recent post, "Back in the early 1960s, banking was still done, more or less, the way it used to be done in America. That is, banks were heavily regulated and one of the reasons they were heavily regulated was the belief that given the nature of financial institutions, bank leaders would naturally push their organizations to the edge of financial leverage and risk taking. The only way to prevent this natural outcome from occurring was to maintain high capital ratios, limit competition, and limit what businesses commercial banks could get into."

Two of the three ways to "prevent this natural outcome" are not in force anymore while regulators are trying to get capital ratios raised. The Volcker Rule is a limited effort to restrain commercial banks from getting into certain activities.

But, all evidence points to the fact that the commercial bankers will continue to behave as they have historically. And, the federal government…and the regulators…will support this effort as long as it is consistent with government policies…like supporting home ownership at lower income levels and selling cars.

It's even tougher for policymakers and regulators to be restrictive on banks when other market conditions are hurting the banks. The low interest rates resulting from the Federal Reserve's policy of quantitative easing is making it harder and harder for the banks to earn a spread on their lending.

The Net Interest Margin, NIM, the difference between what banks earn on loans and what they pay for depositions, has been falling and is expected to continue to fall, at least through the second quarter. "For the biggest four US banks with major consumer lending business, Wells Fargo, Bank of America, JPMorgan Chase and Citigroup, the average NIM fell to 2.64 percent in the first quarter, the lowest level in at least a decade, according to data from Keefe, Bruyette & Woods and SNL Financial," reports Camilla Hall in the Financial Times.

She continues, "The NIMs of 33 US banks that have already reported earnings fell by a median 3 basis points in the first quarter..."

Banks are paying almost nothing on deposits these days and it is a real sign of the weakness in loan demand that loan interest rates are falling to such low levels. And, there seems to be, according to Ms. Hall, no sign that there is a bottoming out in the NIM soon.

This is certainly reason for commercial banks to stretch for yield elsewhere, even in pre-crisis types of innovative products.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.