That article was my first introduction to Tankus's writings, and I must say that I disagree - it's not great.

I found Partnoy's article quite persuasive, and Tankus's response [1] not convincing.

For example, this is confused, in my opinion:

> Remember that collateralized loan obligations are simpler instruments than collateralized debt obligations. There is one layer between individual loans to corporations and CLOs whereas CDOs were two layers away from individual mortgages. Second, because CDOs were made up of mortgage backed securities, what mortgage backed securities were in them mattered. It's important in this context to know what the purpose of CDOs were. They were the equivalent of kitchen leftovers thrown into a lunch special the next day and cooked in such a way as to hide that they aren’t fresh. CDOs generally took the riskier and lower rated portions of mortgage backed securities and made up entire securities out of them.

I disagree. They are quite similar. Mortgages are wrapped into Mortgage Backed Securities, yes, but they are typically not tranched. So it's basically more or less like one big "average" mortgage. Those then are put into a CDO, and tranched. (Two levels of tranching are normally called CDO-squared.)

Next, house values are somewhat floored - a house can loose 30% value, maybe 40 or 50%, but that's really quite unlikely. Debt, per se, will normally also have some significant recovery value if equity goes to zero. However, a comparatively junior loan might easily go to zero if a company goes bad. Partnoy mentions this explicitly and highlights that many underlying loans are fairly junior:

> > We already know that a significant majority of the loans in CLOs have weak covenants that offer investors only minimal legal protection; in industry parlance, they are “cov lite.” The holders of leveraged loans will thus be fortunate to get pennies on the dollar as companies default—nothing close to the 70 cents that has been standard in the past.

Thus, it is CLOs that have something akin to double-tranching, more so than CDOs, contra Tankus's assertion.

> The point is, a proper comparison between mortgage securities and syndicated corporate loan securities would compare the value of outstanding “subprime” Mortgage Backed Securities to outstanding Collateralized Loan Obligations, not to Collateralized Debt Obligations.

No. Compare the CLOs to CDOs, or corporate debt to mortgages, or corporate bonds to MBS.

> In other words, in nominal dollar terms the current CLO market is ⅓ of the size of the subprime mortgage backed securities market then. This actually understates how relatively paltry Collateralized Loan Obligations are.

That's not paltry. A big problem with CDOs was that it was very intransparent where the losses would accrue. The underlying mortgage market went down, say, 10%. If every bank took a 10% hit, fine. But given the opaqueness, it could be that one bank would take a 5% hit, the other a 25% hit. Nobody could tell, and that made every bank suspect. CLOs pose the same problem.

> The key here is to understand that the problems with CDOs were not because of losses on the underlying mortgages. They were dynamite, engineered to explode. The nitroglycerin was not the mortgages but credit default swaps, a type of unregulated insurance that let purchasers bet on whether a specific security was going to fail or not.

Dynamite is engineered to be stable and less explosive than nitroglycerin, and most CDOs were not engineered to explode either. Towards the end, when smart money wanted to short the market, some products were built and sold to long investors so that the smart money could short it, sure. But Tankus doesn't provide evidence about the relative size of that.

> Many of these collateralized debt obligations were filled with credit default swaps tied to the riskier and lower rated tranches of Mortgage Backed Securities which I discussed earlier, which were guaranteed to fail.

Again, CDOs are tranched, MBS aren't generally (except in the sense that a CDO is an MBS in the wider sense). CDOs based on CDS are synthetic CDOs, and yeah, they were constructed and sold.

> One way of recognizing how fundamentally different circumstances are is by examining what happened to AAA rated mortgage backed securities. If, as Partnoy implies, the losses on CDOs were simply a matter of defaults on the underlying mortgages, triple A rated Residential Mortgage backed Securities should have taken losses comparable to CDOs.

That's nonsense. The whole point is that the expected loss of an MBS is independent of correlation, while the expected loss of a CDO tranche depends on correlation. That's really the basic feature - if you have a non-linear payoffs of an underlying, vol enters, and if you have an underlying consisting of many other underliers, the vol depends on the correlation.

And really, that's what this is about. Higher tranches of CDOs or CLOs are safe when correlation is low, but when one massive black swan hits, namely a pandemic, then correlation is not low, and tranches considered safe before might fail. And one still has the opacity of CDOs.

> In fact, it’s likely that collateralized loan obligations made up of the top portion of a portfolio of loans will do the best of any of the Bank’s corporate loans [note: presumably he means the top tranches of such a CLO]. When a bank originates and holds a loan, it immediately takes losses if the borrower defaults. In contrast, it takes very substantial levels of defaults before holders of the top portion, or “senior tranche” of a collateralized loan obligation realize any losses. For any given portfolio of loans, given the same overall default rate and the same loan modifications, senior tranche holders will experience less losses than outright holders of a portfolio of loans. This structure may encourage originating lower quality loans and investors may overpay as a result of tranches being mis-rated by credit rating agencies.

Indeed! That's the problem. Correlation, again.

> However, it can’t be said that this structure, in and of itself, magnifies losses for investors in the senior tranche. In fact, it works as intended- other investors bear the bulk of the risks.

Not the structure in and of itself... but the problem remains: you construct a AAA security out of worse quality loans assuming low correlation, and then a pandemic hits...

Finally, Tankus imputes ulterior motives on Partnoy without any warrant.

To sum up, using Tankus summary:

1. No, collateralized loan obligations are not a major systematic risk to the banking system. - well, he hasn't refuted that claim though.

2. No, collateralized loan obligations are not like Collateralized Debt Obligations. - well, they are somewhat. It's the correlation, baby.

3. The Great Financial Crisis was a credit default swap crisis, not a mortgage crisis. - CDS (like all derivatives) are in net zero supply. So, they just redistribute the wins and losses. The losses came from mortgages. CDS redistributed them, CDOs made them very opaque. CLOs can do the same.

4. Credit Default Swaps are not threatening another banking crisis. - Hopefully. CLOs neither, hopefully.

5. Even the leveraged loan market is only somewhat important macroeconomically. - Ok.

6. Liquidity and capital issues are being handled differently today. - Hopefully. But we also have an unprecedented crisis at hand.

7. Leveraged loan issuance is not the major cause of financial distress among businesses. - Not yet.

In the response to Partnoy's response, Tankus reiterates his misunderstanding:

> I do not think that popular press pieces should present Collateralized Loan Obligations as similar to Collateralized Debt Obligations when the unique and dangerous feature of Collateralized Debt Obligations is that they were securitizations of already structured products and not securitizations of underlying loans directly.

That's not the unique and dangerous feature. The unique feature of a CDO is the tranching, which it does have in common with a CLO.

> Mortgage Backed Securities are the proper analogue to Collateralized Debt Obligations and if Partnoy’s piece were edited to reflect this, a large degree of its rhetorical force would be weakened and the premise of the article may not even hold up to scrutiny.

Same same. Or:

> However, a major overarching point of my piece is that that extreme scenario is only plausible when it is implied that top tranche CLOs are like subprime top tranche CDOs. I’m claiming that this is an apples to oranges comparison.

Same same. It's a valid comparison, in my view.

> Further, it’s important to grasp that to the extent to which the top tranches of CLOs are threatened on the scale that Partnoy speculates about, no other portfolio of loans would be safe.

Correct. But the portfolio of loans wouldn't be rated AAA, while the CLO senior tranches are. That's the problem.

So, I haven't read much of Tankus, but from this one piece (and the reply to the reply), I am not that impressed.

[1] https://nathantankus.substack.com/p/is-there-really-a-loomin...