Beware the Market-Value CLO

The WSJ does a very good job this morning of bringing us all up to speed on the latest developments in the world of the credit crunch. I have a feeling we'll be hearing more about these "market-value CLOs," creatures which seem, at first glance, designed to add leverage to leverage.

CLOs, remember, are collateralized loan obligations: bundles of loans which are then tranched up and sold off. If the loans in question are leveraged loans currently trading at 80 or 90 cents on the dollar, then the investors in any CLOs, especially in the lower tranches, are going to be hurting a lot right now. But market-value CLOs seem to take those leveraged loans and leverage them further: they "depend heavily on borrowed money," says the WSJ.

As a result, market-value CLOs are subject to what is in essence a margin call when the value of their portfolio drops below a certain level. That's what's happening now: the CLOs are being liquidated, which means a forced sale of lots of leveraged loans, which in turn is bringing the price of all leveraged loans down further, which will mean even more liquidation events, and so on and so forth in a vicious cycle.

And to make matters worse, there's also a beastie known as a total return swap which seems to behave in a very similar manner to the market-value CLO.

The thinking behind all of this exotic fauna - you can throw in SIVs and CDOs as well - was much the same: rather than simply give fixed-income investors extra return for extra risk, create vehicles whose return was based on the difference between the extra return and the risk-free rate. Instead of just going long low-quality debt, investors got to go short high-quality debt as well. And of course now they've lost out on both sides of the trade, to disastrous effect.