Law Professor Warns U.S. Facing Banking Crisis Due To Financial Derivatives


Many investments were already at risk, and the nation is “not in the midst of a conventional downturn.”

Frank Portnoy, a law professor at the University of California, Berkeley, warned in the Atlantic that the United States “could be on the precipice of another crash, one different from 2008 less in kind than in degree. This one could be worse.”

  • Portnoy asserts that banking institutions have “learned few lessons” from the 2007 and 2008 crisis.
  • Collateralized debt obligations, or securities packages formed from loans to home buyers, precipitated the 2008 crisis when unsteady loans were rated as secure investments and later defaulted, sending banks and other investors into downturns that rippled through the entire economy.
  • In a similar fashion, collateralized loan obligations have become popular investments throughout the banking and business world.

Portnoy explains,

In place of loans made to home buyers are loans made to businesses—specifically, troubled businesses… These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan.

  • According to Fitch Ratings, more than 67 percent of the 1,745 borrowers in its leveraged-loan database (leveraged loans being the debts that form collateralized loan obligations) have a B rating, which means the “borrower’s ability to repay a loan is likely to be impaired in adverse business or economic conditions.”
  • Nevertheless, most top-tier collateralized loan obligation investments are rated as AAA investments on the grounds that they are highly diversified and that the likelihood all the loans could default is extremely low.
  • However, Portnoy points out that the United States is “not in the midst of a conventional downturn,” and even a diverse collateralized loan obligation is at serious risk.
  • Additionally, Portnoy asserts that “Even before the pandemic struck, the credit-rating agencies may have been underestimating how vulnerable unrelated industries could be to the same economic forces.”

Portnoy presents a “worst-case scenario,” adding that while it is “necessarily speculative” and may not take place, the point is “that it could” and “That alone should scare us all—and inform the way we think about the next year and beyond.”

  • As the summer of 2020 progresses, leveraged-loan defaults increase, and bankruptcy courts begin to “buckle under the weight of new filings.”
  • Those who hold leveraged loans will be “fortunate to get pennies on the dollar as companies default—nothing close to the 70 cents that has been standard in the past.”
  • Banks and other large institutions investing in these collateralized loan obligations, such as insurance companies and pension funds, will “begin to feel the pain of these defaults.”
  • These losses will be compounded by other economic impacts of COVID-19 leaving institutions with “insufficient cash reserves” that force them to “sell assets into a dour market.” As a result, “The prices of leveraged loans, and by extension CLOs, will spiral downward.”
  • Rumors will arise that one bank is near collapse, and when “frantic meetings” fail to prop it up, “The faltering bank will fail, with others lined up behind it.”

Portnoy warns,

The financial sector isn’t like other sectors. If it fails, fundamental aspects of modern life could fail with it. We could lose the ability to get loans to buy a house or a car, or to pay for college. Without reliable credit, many Americans might struggle to pay for their daily needs. This is why, in 2008, then-Treasury Secretary Henry Paulson went so far as to get down on one knee to beg Nancy Pelosi for her help sparing the system. He understood the alternative.

… If we do manage to make it through the next year without waking up to a collapse, we must find ways to prevent the big banks from going all in on bets they can’t afford to lose. Their luck—and ours—will at some point run out.

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Economics, Finance and Investing