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September 23
13:29 2019

Public Policy Analysis & Opinion

By Kevin P. Hennosy


NAIC works to make a liar out of Gertrude Stein in defense of collateralized loan obligations

“There are three things in life that are real: God, human folly, and laughter. Since the first two are beyond our comprehension, we must do what we can with the third.”—John F. Kennedy

The National Association of Insurance Commissioners (NAIC) reports that insurance sector holdings of collateralized loan obligations (CLO) have grown at an aggressive rate since 2010. While they are a small part of the sector’s total investment portfolio, insurers love CLOs.

The report compiled by the NAIC’s Securities Valuation Office (SVO) welcomes the expansion. As such, the report should prove quite useful to insurance carriers and other players in the capital markets. If ever questioned about the safety and soundness of CLO investments, they can present the document as a “regulatory” perspective that expresses no qualms about CLOs’ investment risk.

Of course, the NAIC is not a regulatory body, but the group’s name makes it sound like one.

According to a separate document, an NAIC primer on CLOs published in 2018, the insurance sector historically holds less than 1% of its cash and assets in these instruments. According to the most recent report, insurers have doubled their holdings in CLOs.

[As] the NAIC primer document explains, CDOs and CBOs proved to be “volatile asset types,” which the NAIC asserts is not the case with CLOs.

The NAIC/SVO report states that as of the end of 2018, about 2% of the insurance sector’s investment portfolio consists of CLOs. This percentage equates to approximately $122 billion.

In terms of industry segments, life insurers report holding about 77% of the insurance sector’s CLO portfolio. Property and casualty insurers hold about 20% of the portfolio and health insurers about 3%.

As the NAIC/SVO report states:

During the last 10 years, U.S. insurer exposure to CLOs has been increasing. Notwithstanding, life companies have consistently accounted for the majority exposure, and CLOs have consistently accounted for a relatively small portion of the industry’s overall bond investments.

The NAIC/SVO report cautiously avoids alluding to the role CLOs played in the toxic financial markets in the first decade of the 21st century. Nor does the report discuss the destructive ways in which financiers have used these instruments to fund corporate raiders and leveraged buyouts, which cripple U.S. manufacturing.

The report communicates one message: “Remain calm. All is well!”

Well, let’s hope so! The alternative offers another economic Troika of Turpitude; the sequence of bubble, bust, and collapse.

Still, let’s remember that someone bet his entire career on “New Coke.” Someone probably said beautiful things about DDT, and at one time cigarette companies advertised “health” claims that they associated with their products.

Still, providence demands that we accept the NAIC’s history-blind assessment with a positive attitude and good humor.

As an investment product, CLOs attract big money in response to the Federal Reserve Open Market Committee policy. The committee tentatively began raising interest rates in 2015. A CLO investment pays more as interest rates increase because the loans that make up the investment pool feature “floating” rates that react to Fed policy.

Indeed, some of America’s wealthiest families recently flocked to the CLO market, which attracted interest from the investment trade press.

So it should surprise no one that the NAIC/SVO report writers vigorously labored to describe CLOs as being as helpful as a Boy Scout at a convention of elderly ladies. Why rock a boat that carries Bill Gates and a chunk of his money?


What is a CLO?

The well-behaved financial press will describe the CLO as a pool of loans that produces revenue from interest. Also, the CLO “arrangers” divide the pools into three risk-based tranches from which investors may purchase “slices.” The risk-based tranches allow investors to make purchases shaped by the combination of their risk-tolerance and avarice.

The pooling mechanism gives the arrangers the opportunity for arbitrage—receiving income by buying and selling driven by price differentials of like assets. Where there is arbitrage, there also be dragons—or the risk of catastrophic financial loss.

This use of the term “pool” proves problematic on several levels. For example, if one divides a pool into thirds, do not three pools result? And just how does one “slice” a pool for transfer?

Why not use the term “silo” rather than “pool”? That usage might be evidence of Midwestern bias?

And, while we are at it, what of this term “arrangers”? The word holds meaning in music or the aesthetic placement of objects such as flowers. The odd application of the term “arrangers” to a financial transaction triggers a suspicious thought: Does the employment of this term impede the implementation of some protective regulation?

Awakened echoes

As noted, the NAIC/SVO report and the NAIC primer document endeavor to build a wall between CLOs and the tarnished reputation of CBOs (collateralized bond obligations) and CDOs (collateralized debt obligations).

CBOs and CDOs became associated with what amounted to unregulated and lightly reserved faux-insurance products on loan defaults, which allowed highly toxic financial institutions to detoxify their financial statements by loading them into a structured security and selling parts of it to any chump with access to real money.

The CLO “arrangers” want to avoid association with the CBOs and CDOs because financial pirates used them as instruments to rob and ruin the world economy in the first decade of the 21st century. Some unforgiving people still hold a grudge over that catastrophe, which evaporated retirement funds, home values, and access to gainful employment.

Still, those haunting shared traits keep rearing their ugly heads. The CLOs’ arrangers use time-tested termsto describe the tranches: (1) equity tranche, which consists of the loans that pose the highest risk of default; (2) mezzanine tranche, which provides some risk and rewards to growth-minded investors; and (3) senior tranche, which consists of loans to borrowers who present little risk of default, unless all “heck” breaks loose or we find out that widespread fraud exists—again.

Those who remember recent financial history will blanch when they see the return of that nomenclature.


The NAIC pushes aside these comparisons by trying to describe them as financial white bread:

About 5%-10% of CLO transactions include “balance sheet” CLOs, whereby the mechanics are the same as arbitrage CLOs, but they differ in that balance sheet CLOs are structured primarily as a funding source for the issuer (usually a bank or specialty finance company). With balance sheet CLOs, the issuer securitizes the bank loans (middle market or broadly syndicated) off its balance sheet into an SPV, for the purpose of raising capital, and it typically retains the equity tranche.

With the “clarity” of that description of an unregulated financial activity, what could go wrong? After all, the term “specialty finance company” appears in the Bible, right? Or was that term “money changers”?

Furthermore, the NAIC primer document explains, CDOs and CBOs proved to be “volatile asset types,” which the NAIC asserts is not the case with CLOs. Why would one even think CLOs consist of volatile asset types when charming people who wear costly clothes visit NAIC meetings and SVO offices and scoff at the idea that CLOs are anything like CDOs and CBOs? Those friendly and well-dressed people bring gifts of the most exceptional Kool-Aid, and they teach us to handle serpents!

And some Smarty Pants may add that those tranches received their designations using the same processes as CDOs and CBOs, which proved to be smoke and mirrors.

Forget the Kool-Aid and take a deep quaff of Victory Gin. Now we understand: That was then. This is now. Human nature completely changed in the years since the last crash, and we have a “new economy!” Big Brother tells me so!

A rose is a rose?

The NAIC primer document and the NAIC/SVO report both assume that investors can trust the pool “arrangers” to avoid submission to avarice or other forms of mania. After all, these arrangers include banks, subsidiaries of large insurance companies, and shadow bank entities! Who has ever heard of a financial scandal associated with such institutions?

Also, the NAIC stresses that a “skin in the game rule” promulgated by the Federal Reserve under authority granted by the Dodd-Frank Act of 2010 protects investors by requiring arrangers to retain part of the highest-risk loans contained in the CLO. Of course, when the D.C. Federal Appeals Court struck down that rule in February 2018, the logic behind the NAIC’s argument proved less convincing.

So now the NAIC seems to be left with the argument that CLOs are not CBOs or CDOs because the investment instruments have different names.

The NAIC finally hangs its hat on the following epistemological hook: CLOs differ from CBOs and CDOs because all three instruments have different names!

Collateralized LOAN Obligations

Collateralized BOND Obligations

Collateralized DEBT Obligations

Each of these three product names uses a different word to describe a transaction to borrow capital! As Yogi Berra should have said, “It’s as plain as the ear on your face!”

So keep moving! There is nothing to see here!

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.

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