In lieu of my regular economics & investing column, I’m posting a brief update on the threat to global financial markets from commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs).
Since 2006, I’ve warned SurvivalBlog readers about the systemic risk posed by disappearing counterparties, in the trillion of dollars of notional value in derivatives. If you haven’t yet read my background piece about that, please take the time to do so: Derivatives–The Mystery Man Who’ll Break the Global Bank at Monte Carlo.
Just a week ago, this headline was seen in newspapers around the world: Blackstone Defaults On $562MM CMBS As It Keeps Blocking Investor Withdrawals From $71BN REIT. With the recent turn in the real estate market, something like this was inevitable. And with any further deterioration of the real estate market, we can expect to see many other mortgage-backed securities bundles and similar derivatives fail, in the coming months.
If the real estate markets — both commercial and residential — suffer sharp declines, then the corresponding drops in commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and other real-estate paper-backed derivatives will be enormous. Whenever a debt instrument is derivative (an abstraction), it can amplify the effect of a market swing, whether that is positive or negative. In good times, these debt bundles are very profitable. But In bad times, they can amplify in the opposite direction. I should also mention that some of these derivative instruments are abstractions of abstractions. (“Bundles of bundles.”)
And, although they are less abstract than bundled CMBS/CLO derivatives, the more traditional real estate investment trusts (REITs) are also at risk, presently.
Remember: If you buy land, then buy the land itself, not some paper abstraction!
Oh, and even if you don’t have any direct exposure to real estate derivative paper, then there is still some risk to you. Why? Because as taxpayers, we may be on the hook to bail out the bad investments of a bunch of high-rollers. We all learned that lesson in the aftermath of the last CDO crisis, in 2008. Do you remember the Bear Stearns and Lehman Brothers debacles? That was dramatized in the movie The Big Short. (A film that is well worth watching.) This could all be played out again, in much the same way.
Expect to see the word “tranches” pop up again, soon.
History doesn’t repeat, but it often rhymes. – JWR