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Dalrymple column: Community banks might save us from next meltdown

Pat Dalrymple
Bankers’ Hours
Pat Dalrymple

Collateralized Loan Obligations (CLOs) are securities backed by loans to corporations. Increasingly, banking industry pundits are positing that these instruments could trigger a new wave of defaults and failures, just like 2008.

Back then, the culprit was Collateralized Debt Obligations (CDOs). These instruments were backed by mortgages; same concept, different debt.

Problem was, in 2008, the mortgages were bad loans that borrowers couldn’t repay. Problem now is a big number of the CLOs are backed by credit to large corporations that were in serious trouble before the pandemic, as in over a trillion dollars’ worth of questionable paper. Now those companies are lined up at your neighborhood bankruptcy court, filing for Chapter 11 protection. And they’re being joined by businesses that weren’t on the brink on New Year’s Eve, 2020, like Hertz, but are now.

Big banks, the TBTFs (Too Big to Fails), have invested in CLOs in a big way, but they’ll tell you they’re gold-plated assets because the bank’s position is protected. To make a long story less confusing, these securities are sold in tiers called tranches. The lowest tier is for gamblers who want to make a bet at big odds. However, banks buy positions in the highest tranche, which means all of the lower tiers pretty much need to go bad before the institutions are in harm’s way. But that could never happen, could it?

Some savvy observers of financial markets are now saying, “yes, it could.” In moving money, there’s a saying, “Sewage runs downhill.” … Well, a shorter word is generally employed, but you get the idea. Meaning that a bad loan always, eventually, ends up with the originator of the credit. In this instance, the drain is clogged and the sewage is backing up, maybe to the point where the big banks will be neck deep in the muck, chanting, “Don’t make a wave.” How many times, when financial bad news hits, have we heard the comment that begins, “Nobody thought that …” You’d think we’d learn that what nobody thought could happen, usually does, sooner or later.

So there seems to be concern that we might be on the cusp of a new banking meltdown, because a big portion of that trillion, maybe close to all of it, could default. Which got me to thinking: There’s a backstop in the banking system that people a lot smarter than I seem to forget about: community banks, the small institutions under $1 billion in assets.

These banks shy away from complex investment instruments for a variety of reasons, and one very good one is that they don’t understand them. Which doesn’t mean they’re dumb; in fact just the opposite. In making sophisticated investment decisions — and it doesn’t get more esoteric than buying a position in CLOs — the big banks rely on the rating services, Moody’s, Standard and Poor, and Fitch. It’s kind of, “We go all the way with triple AAA.” On the other hand, the little lender makes direct loans to borrowers that they know, or come to know, through documentation and analysis; doesn’t mean they don’t make a bad loan, but they strive, with remarkable success, not to make a loan badly.

Any bank contemplating buying slices of CLOs would be required by regulators to have competent people to run the operation, and these new hires come with high six figure, low seven, salaries. Our favorite institution in this column (fictitious), Second National Bank of Downriver, Montana, wouldn’t think about doing such a crazy thing, especially when they’re doing just fine doing what they’re doing. And people who make a million a year never say, “I think we’d better close this whole thing down, because it looks like all these assets are going in the tank.”

We should be very scared when anybody says an investment asset is almost as safe as cash. Remember that Fannie Mae and Freddie Mac stock in 2007 was given the same value as cash on the balance sheets of banks and thrifts (S&Ls) by bank regulators. We all know what happened to Freddie and Fannie stockholders in 2008.

Default chaos at the top of the banking food chain would be painful to many and traumatic to some, but community banks would be happy to assure you that, when the dust settled, they could very efficiently replace what they believe is the redundancy of big bank branches on every street corner.

Maybe, for the peace of mind, not to mention the pocketbooks of us all, it’s time that big banking institutions adopt a new business model: banking.

Pat Dalrymple is a western Colorado native and has spent more than 50 years in mortgage lending and banking in the Roaring Fork Valley. He’ll be happy to answer your questions or hear your comments. His e-mail is pdalrymple59@gmail.com.


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