Investing in unbundled risk can be extremely dangerous. Alan Greenspan was never more wrong than when he defended the deregulation of derivatives in 1999:
"These new financial instruments are an increasingly important vehicle for unbundling risks. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it."
The catch: In theory, Greenspan was right. In practice, however, derivatives weren't being used to allocate risk to people who wanted it. Instead, they were used to hide risk, to make risky loans look like ultra-safe securities with triple-A credit ratings, and to sell them to unsuspecting investors who had no idea what they were buying.
Driving the news: The Federal Reserve and others, including Janet Yellen, have been worrying a lot about the rise in leveraged lending. High-risk, junk-rated loans to deeply indebted corporate borrowers now total well over $1 trillion, and already lawsuits have started flying after loans have gone bad. But unlike Greenspan's derivatives, leveraged loans are well-understood and held by institutions that understand their risks.
- Nobody's kidding themselves that these loans are safe. Defaults are priced in, with credit spreads already above their 20-year average, per the Fed.
- The biggest loan investors are banks and insurance companies, and the risk is dispersed enough that even significant financial losses on these loans would not cause a broader systemic risk. Elsewhere, CLOs comprise a very small part of most investors' asset allocation.
- $1 trillion is a lot of money, but it's small in comparison to the combined capitalizations of the Big Tech stocks. Investors in Facebook, Apple, Amazon, Netflix and Alphabet lost a total of $650 billion in the fourth quarter of 2018, with no systemic spillovers.
What to watch: So long as the music keeps playing, the banks will keep on dancing. When one loan comes due, it will be refinanced with another, or interest will be paid in kind. When the music stops, defaults will spike. The big question is what then happens to the borrowers, their vendors and their employees.
- U.S. bankruptcy law is designed to keep bankrupt companies operating as going concerns. The ownership might change, and the shareholders generally get wiped out, but it's possible for employees and vendors to emerge from the process in an improved condition. As we saw with Toys "R" Us, however, that doesn't always happen.
The bottom line: If the leveraged loan market starts collapsing under its own weight, the broader consequences will likely be small. On the other hand, if the loan market fails as a result of a broader economic contraction, highly indebted companies will be at much higher risk of shutting down entirely once they default.