A Hidden Risk That Could Trigger Financial Collapse

I can’t shake the feeling we’ve seen this movie before.

Here we are, years after the 2008 meltdown, yet Wall Street has cooked up another alphabet-soup security that promises high returns with minimal risk – until it doesn’t.

I’m talking about Collateralized Loan Obligations (CLOs), complex bundles of corporate loans that are being hailed as safe by many of the same types of experts who once swore mortgage-backed securities could never fail.

If you find yourself asking, “Wait, haven’t we seen this before?”, you’re not alone. CLOs may be composed of corporate loans instead of subprime home mortgages, but in structure and spirit they “walk and talk” like the infamous Collateralized Debt Obligations (CDOs) that blew up the financial system in 2008.

Just as CDOs pooled together thousands of sketchy mortgages, CLOs bundle together hundreds of loans to below investment grade businesses. In other words, CLOs are essentially CDOs holding corporate debt instead of home loans.

Structurally, a CLO, like a CDO, is a towering layer cake of risk. Loans go into a special vehicle, which then slices the pooled debt into tranches with varying seniority. The top slice gets an AAA rating and first dibs on loan payments; the bottom equity slice eats the first losses but could earn high returns if things go well. This was exactly the formula with mortgage CDOs. Back then, we had supposedly rock-solid “AAA” tranches composed of dubious subprime loans. Today we have AAA-rated CLO tranches – but don’t be fooled. The AAA rating is deceiving because inside a typical CLO, you won’t find a single underlying loan rated AAA, AA or even A loan.

In fact, a recent analysis found 67% of the 1,745 borrowers in a major CLO loan database carried a B rating – essentially junk. Two-thirds of those loans would likely “lose money in economic conditions” similar to a serious downturn.

Sound familiar? It should.

In 2008, AAA-rated CDOs were stuffed with BBB-rated subprime bonds; in 2025, AAA CLOs are stuffed with B-rated corporate loans. We’ve just swapped who’s borrowing – homeowners then, corporations now – but the game is the same.

The CLO market has exploded in size, now even bigger than the subprime CDO market at its peak. In the 2000s, easy mortgages fueled a $640 billion CDO boom; in the 2010s, cheap corporate credit fueled a $750 billion CLO market by 2018. And it kept growing. By January 2025, the CLO market size was $1.38Tn. Just as easy mortgages fueled economic growth in the 2000s, cheap corporate debt via CLOs did so in the 2010s – and many companies binged on it.

Critically, the perceived safety of CLOs rests on the same shaky pillar that propped up CDOs: diversification. Rating agencies assume that a pool of 200 loans won’t all sour at once. In theory, the CLO’s loans are spread across industries and regions, so a downturn in one sector shouldn’t tank the whole portfolio. This default correlation math earned many CLO tranches their coveted AAA ratings. But we heard a similar tune in 2006: housing markets are local, they said – Florida might crash but Nevada and New Jersey will be fine. They were wrong.

When the economy falters broadly, correlations tend to shoot up – suddenly everything goes wrong together. In 2008, the myth that home prices in different cities were uncorrelated got busted as a nationwide housing decline sent highly rated CDO tranches into freefall alongside the lower tranches. The same risk looms for CLOs: the idea that dozens of highly indebted companies won’t default around the same time in a serious recession may be a dangerous fantasy. The safety of AAA CLO bonds depends crucially on how correlated those loan defaults become. If correlations spike – say, because an economic downturn or rate shock hits many businesses at once – the top-tier tranches could be a lot less resilient than promised.

To be fair, CLOs did learn from a few of the CDO mistakes. They are generally less complex – for example, they’re usually not packed with exotic derivatives or other CDOs (CLOs of CLOs are rare, whereas CDOs of CDOs were common pre-2008). CLOs also typically have thicker cushions of junior tranches below the AAA layer, ostensibly giving more protection to the senior investors. A modern CLO’s AAA tranche might be ~60–70% of the deal (meaning 30–40% subordination beneath it), whereas some subprime CDOs infamously had thin 20% buffers.

These structural tweaks mean if things only get slightly bad, CLOs’ top tranches could hold up better than CDOs did. But if things get really bad? The same fundamental flaw emerges: those buffers are only as good as the assumption that not too many loans default at once.

As the BIS (Bank for International Settlements) pointed out in a comparison, even a sturdier structure can be overwhelmed if the underlying asset quality deteriorates and defaults cluster more than expected. And guess what – underwriting quality has deteriorated in the frenzied hunt for yield.

Prior to 2008, subprime lenders were handing out “no-doc” mortgages like candy; similarly, in recent years leveraged loans without maintenance covenants increased from 20% in 2012 to 80% in 2018, meaning most loans in CLO pools now lack traditional safeguards. The share of ultra-low-rated loans (B–) in CLOs nearly doubled to 18% as of a couple years ago. In short, CLO collateral today is riskier and more weakly protected than a decade ago, despite the outward appearance of higher-rated tranches. Strong investor appetite led to “a deterioration in underwriting standards” for both subprime mortgages back then and leveraged loans now. Bottom line: we’re making the same mistakes in a different market.

Low Defaults Masking Risk

A fact often touted by CLO bulls is that no AAA-rated CLO tranche has ever defaulted in the history of the market – not even through the 2008 crisis. Even during the worst of the Global Financial Crisis, when CDOs imploded left and right, most CLOs (which held corporate loans, not mortgages) came through with only minor wounds.

In 2020’s brief pandemic recession, CLO structures again survived; their market prices plunged for a time, but actual defaults on the bonds were minimal. This track record has led to a pervasive sense of confidence – some would say complacency – about the product.

It’s the old trap of using the recent past to predict the future. CLOs haven’t blown up yet, so many assume they never will. But people once said U.S. home prices had never fallen nationwide, right up until they did. Past performance is no guarantee of future results – especially when conditions are changing.

Yes, CLOs navigated 2008 and 2020 fairly well – but one reason was that policymakers bailed out the broader system quickly, short-circuiting the worst-case scenario. When COVID hit, for instance, the Fed slashed rates to zero and opened liquidity floodgates, including buying corporate bonds; the corporate credit market got a lifesaver, which indirectly saved CLOs from experiencing a prolonged default cycle.

History’s absence of catastrophe is as much due to extraordinary rescue measures as to inherent safety. It’s worth remembering that CDOs were considered solid for years, until they suddenly weren’t. In 2007, AAA CDO tranches still had a spotless default record; by 2009, many of those same tranches were either defaulted or close to worthless.

The transition from “safe” to “toxic” can happen shockingly fast once underlying conditions turn. CLOs have never been tested at their current scale in a protracted, ugly recession with high interest rates squeezing borrowers. As the IMF observed in 2024, this entire asset class (leveraged loans and private credit) “has never experienced a severe economic downturn at its current size and scope” – what happens in a truly adverse scenario is largely uncharted territory.

Another reason CLO performance has been okay so far is that the risk has been shuffled out of the banking sector and into the hands of investors who are often willing (or forced) to hold through turmoil, which can delay the recognition of problems. In 2008, banks and investment banks holding toxic CDOs were immediately at risk of collapse when those assets soured, which made the crisis very acute. CLOs, by contrast, are mostly held by long-term institutional investors (think insurance companies and funds) who don’t mark to market as aggressively. That can create an illusion of stability – prices might fall, but insurers aren’t going to dump their AAA bonds at fire-sale prices (in fact, regulations often encourage them to hold such assets to maturity).

Losses can thus hide or take time to materialize. But make no mistake: the risk is there, just in different hands and perhaps slower-moving. The Fed’s own analysis in 2020 noted that institutional investors had “sizable exposures to risky CLO tranches, which appear to be larger than what market participants believe.” In other words, the market may be underestimating who’s really holding the bag and how much they could lose. The risk didn’t evaporate; it changed form and location.

So where did it go? Largely to the shadows of the financial system – pension funds, insurance companies, asset managers, and hedge funds, rather than the big banks and brokers that were center stage in 2008. This migration was by design: post-2008 regulations (like Dodd-Frank and the Volcker Rule) discouraged banks from loading up on the kind of risky structured assets that nearly killed them before.

Banks learned their lesson and now mostly stick to the safest slices of CLOs (and even those they keep in full view on their balance sheets). In fact, the Fed Chair and Treasury Secretary have often pointed out that banks today hold only the high-grade CLO tranches, implying there’s little cause for concern. And it’s true – banks hold only about 18% of outstanding CLOs, mostly AAA pieces. But that doesn’t mean the risk is gone; it’s just moved to “non-banks” that are outside the traditional regulatory spotlight.

The New Bagholders: How Pensions and Insurers Became the CLO Shock Absorbers

One of the biggest shifts since 2008 is who ends up holding these structured products. Back then, complex mortgage securities found their way onto bank balance sheets and off-balance-sheet vehicles, and even a big insurer (AIG) via credit default swaps. When the music stopped, taxpayers bailed out those firms (and by extension, the investors). Today, CLO risk has largely migrated to pension funds and insurance companies – institutions managing the savings of everyday people.

Insurance companies have become the single largest holders of U.S. CLO securities, far outpacing banks or pension funds. According to Federal Reserve data, by the end of the 2010s U.S. insurers alone held about one-third of all U.S.-held CLOs – the biggest chunk of any investor type. A 2018 breakdown showed insurers holding roughly $112 billion of CLO notes (33%), whereas pension funds held about $22 billion (~7%). Banks held around 18%, similar to mutual funds (18%).

In short, the lion’s share of CLO exposure had shifted to institutional investors like insurers, asset managers, and pensions. Fast forward to today and the trend continues. By 2022, estimates put U.S. insurers’ share of CLO holdings at ~22% of the market, with banks around 18% and mutual funds 15%. Pension funds, hedge funds, and other U.S. investors together held about 14%, and about 30% of CLOs were held by foreign investors (which likely include overseas insurers and funds). In total, roughly three-quarters of U.S.-held CLO exposure sits with non-bank institutions, not with the big banks.

This isn’t just an academic shift – it has real implications for stability. Insurance companies, particularly life insurers, are pouring money into CLOs as they search for higher yields to match their long-term liabilities. By year-end 2023, U.S. insurers’ CLO holdings reached $271 billion, more than double what they held five years earlier.

Even more striking, over 80% of those CLO investments were rated BBB or higher, and 41% were in AAA tranches. On the surface that sounds comforting (they’re mostly in investment-grade notes). But remember, those ratings depend on everything going right. And insurers haven’t shied away from riskier slices either – an earlier Fed study found just over half of insurers’ CLO holdings were actually in the mezzanine or junior tranches, not the ultra-safe AAA.

Other institutions are in a similar boat: about a quarter of pension funds’ CLO holdings were in the risky mezzanine/equity layer as well. There’s evidence even some traditionally conservative players are reaching for yield by venturing into the lower-rated “gut” of CLOs. For example, reports in 2024. noted that pension plans and insurers have been piling into funds that invest in CLO equity tranches – essentially the first-loss positions – hoping to boost returns. That is the equivalent of loading up on the equity of subprime CDOs in 2006 – a bet that paid off until it catastrophically didn’t.

Why should we care if insurers and pensions hold these things? Because these institutions are the bedrock of Main Street’s financial security. If a bunch of CLOs go sour, it won’t be Goldman Sachs or Citigroup bleeding – it’ll be, say, the state employees’ retirement fund, or the life insurance company that guarantees your annuity.

The risk has shifted from the highly scrutinized banking sector to corners of finance that, while regulated, don’t face the same daily market discipline or transparency. It’s quieter, but it’s still there. Financial watchdogs have noticed: The Financial Stability Board warned in late 2019 that insurers are now the largest non-bank holders of CLOs, including lots of lower-rated tranches, so stress in CLOs “could therefore have negative implications for insurers, pension funds and other non-banks.”

This also means the dynamics of a crisis would differ from 2008. Back then, when banks started keeling over, it triggered immediate panic and government interventions (nobody wanted ATMs to stop working).

If CLOs blow up, the pain shows up in more delayed, insidious ways: an insurance company quietly hemorrhaging until it can’t meet obligations, or a pension fund suddenly reporting a huge shortfall and asking a state government for a bailout. The transmission is a bit slower but ultimately lands in the same place – the public’s pocket.

Either retirees and policyholders take a hit, or taxpayers step in to fill the gap.

The Mirage of Diversification

At the core of CLOs’ supposed safety is the idea that diversification will save the day – that by holding hundreds of loans from different industries, a CLO can absorb a few defaults here and there.

This works until it doesn’t.

The risk that too many loans go bad at the same time is the Achilles’ heel of the whole scheme. And right now, we have a perfect storm brewing that could make default correlations skyrocket: higher interest rates and a broad economic downturn.

Consider what’s happened in the last 18 months: The Federal Reserve jacked up policy rates from near-zero to around 5% in an effort to curb inflation. Those higher rates directly raise the cost of all those floating-rate leveraged loans sitting in CLO portfolios. As rates have climbed, struggling companies suddenly face much higher interest expenses on their debt. Many of these borrowers were barely covering their interest when rates were low; now they’re underwater.

Already we’ve seen corporate defaults start to tick up from historic lows, roughly doubling over the past year (from ~1.5% to over 3%) as rate hikes bite into firms’ finances. Fitch Ratings projects loan defaults could rise to about 3.5–4.0% in the near term, the highest in over a decade, due to the combo of high rates and an economic slowdown. That may not sound huge, but remember that’s an average – in a severe recession, default rates in junk debt have spiked into double-digits before (around 10–12% at the worst of 2009). CLOs haven’t seen anything like that in their modern incarnation. If, say, 10% or 15% of the loans in a CLO default over a short period, the lower tranches would be wiped out and even some supposedly safe tranches could be imperiled.

The danger is that a broad downturn - which appears to be materializing at the moment, due to rising uncertainty, government employee layoffs, and trade wars, will clobber a large portion of the companies in these loan pools all at once, overwhelming the benefits of diversification.

When the economy goes south, it’s not just one industry that struggles – it’s many. Consumers cut spending, affecting retailers, restaurants, manufacturers, you name it. Rising interest costs hit every leveraged borrower across the board. It’s a bit like the housing market in 2008: it wasn’t one city or one region that collapsed – it was the entire national market.

CLO managers do try to diversify across industries and geographies, but no CLO is truly immune to a deep U.S. recession or credit crunch. In fact, recent analysis highlights that many leveraged loan borrowers are remarkably similar in their vulnerability: a huge chunk are rated single-B, meaning by definition they are very sensitive to any adverse business conditions.

When credit conditions tighten, most of those B-rated firms will struggle together. The correlation assumptions that rating agencies used (which often assume only a modest portion of loans default in unison) could prove far too optimistic.

Even diversification across regions might not help in the event of a broad economic recession. U.S. and European CLO markets are somewhat separate, but a global recession would hurt both. Within a U.S. CLO, loans might be spread across states or sectors, but a sharp rise in interest rates or a spike in input costs (like oil) hits across the spectrum.

During the brief COVID shock in March 2020, the average price of leveraged loans plunged by ~20 percentage points (from nearly 100¢ on the dollar to around 80¢) in a matter of weeks. That wasn’t because one or two loans defaulted – it’s because investors suddenly anticipated a wave of defaults everywhere. While prices later rebounded (thanks to the Fed’s intervention), it was a taste of how quickly correlations in credit can go to 1.0 when fear takes hold.

In essence, the touted benefits of diversification in CLOs may prove illusory when they’re needed most – much like how mortgage CDOs that were theoretically diversified by geography all sank together in 2008.

Not every underlying loan has to become stressed to have serious consequences. If enough of them falter together even the higher tranches could face losses or at least lose their investment-grade status.

Moreover, if loan defaults accelerate, managers might trade around and try to mitigate losses, but they can’t magically exit a collapsing market. In fact, trading could become impossible if liquidity evaporates (who’s buying junk loans in the middle of a crisis?).

The whole mechanism can seize up.

How a CLO Collapse Could Trigger a Wider Crisis

Let’s map out how trouble in CLO-land could transmit into a broader financial crisis. The key thing to grasp is that CLOs link the real economy (companies borrowing money) with the financial system (institutions investing in those loans). When that link snaps, it can create a feedback loop of pain.

1. Rising Defaults in the Real Economy: Start with a slowing economy – say unemployment rises, consumer spending falls, or profits drop. Highly leveraged companies (the ones in CLO portfolios) begin to miss interest payments or violate debt covenants. Defaults start to surge. Perhaps initially it’s confined to the weakest firms, but as the downturn deepens, even stronger firms struggle. At the same time, high interest rates mean these companies can’t easily refinance their debts; the usual escape hatch (borrow new money to pay off old loans) is largely shut. A wave of corporate bankruptcies ensues – not just isolated cases, but a significant percentage of the loan universe.
2. CLO Waterfalls Kick In: Inside the CLOs, the waterfall structure starts allocating losses. First, equity tranches are wiped out – that’s expected, they’re the buffer. Next, lower-rated debt tranches (say the BB or B rated slices) start taking hits. Interest that was supposed to go to junior tranches gets diverted to pay senior tranches due to failure of over-collateralization tests (CLOs have built-in rules: if collateral values fall or too many loans default, cash flows that normally would trickle down to equity or mezzanine holders get redirected to pay down the senior notes). Mezzanine investors see their income cut off and principal eroded. If defaults are severe, even some of the BBB or A rated tranches could face write-downs. Keep in mind: by design, CLO equity and junior notes absorb losses up to a point – but beyond that point, losses will creep up the chain. The “larger loss-absorbing cushions” of CLOs help, but they are not infinite.
3. Institutional Losses and Strain: Now, who holds those losing tranches? Hedge funds and specialized credit funds probably hold a lot of the equity and B/BB tranches – they’ll get hurt first. Some will fold or face investor redemptions, but that’s not yet systemic. However, insurance companies and some pension or mutual funds hold a sizable chunk of the BBB/AA tranches (and even some of the BBs). As those tranches get downgraded or suffer losses, these institutions take hits to their capital and earnings. Insurers might have to mark down the value of their holdings and boost reserves. A life insurer counting on CLO income to fund annuity payouts could face a shortfall. Pensions see the value of their fixed-income portfolio drop and their funding status worsen – they might swing from healthy to underfunded quickly, or an already underfunded plan becomes deeply in the hole.
4. Fire Sales and Market Contagion: If multiple institutions are under stress, we could see forced selling and liquidity crunches. For instance, imagine a couple of big insurance companies with outsized CLO exposure get nervous and try to offload some tranches to raise cash or reduce risk. In a crisis, though, buyers vanish – the market for CLO paper could freeze up, much like the CDO market did in 2008. Attempted sales just push prices down further. Mutual funds holding CLOs (some open-end funds and ETFs do hold CLO debt) face investor withdrawals and have to liquidate at any price. This becomes a downward spiral – asset prices plummet, even healthy loans trade at deep discounts, which in turn forces more writedowns on everybody still holding. It’s a classic deleveraging cycle. The CLO market, now over a trillion dollars including global issuance, is large enough that a crash in CLO values would send shockwaves through credit markets globally.
5. Credit Crunch for Companies: Here’s where it feeds back to the real economy. CLOs are a major buyer of corporate loans – they have funded a huge share (over 50%) of the leveraged loan market. If CLO issuance halts (no one will buy new CLOs during a fire sale) and existing CLOs are instead trying to sell loans, the supply of credit to companies dries up. Even relatively healthy companies that need to refinance maturing loans in, say, 2026 suddenly find no lenders willing to roll their debt. Banks might be cautious too (they’re dealing with their own issues and many had pulled back from direct leveraged lending, relying on CLO demand which is now gone). Companies that were counting on refinancing or new loans can’t get them, leading to more defaults and layoffs. It becomes harder for businesses to roll over even good debt, spreading the wave of bankruptcies beyond just the weakest firms. In effect, a CLO market implosion could freeze the entire leveraged loan market, very much like the way the subprime CDO collapse froze mortgage lending in 2008. This credit crunch then amplifies the recession, making it deeper and more prolonged.
6. Hit to Banks and Financial System: Up to now, banks have been on the sidelines (apart from losing their ability to syndicate new loans). But in a severe scenario, banks won’t be unscathed. Remember, U.S. and foreign banks still hold about 18% of CLOs, mainly the AAA tranches. If the nightmare unfolds where even AAA tranches are at risk (say, they haven’t yet defaulted but could if things worsen), banks would face huge mark-to-market losses on those holdings. Even before outright default, downgrades of CLO tranches from AAA to BBB (or worse) would force banks to increase capital against them or sell them at a loss. Moreover, banks often extend credit lines to investment vehicles and players in this ecosystem – for example, a bank might have provided a warehouse line to a CLO manager to accumulate loans before packaging, or lent to a hedge fund that’s now bleeding. As those counterparties falter, banks can get hit indirectly. And of course, if the corporate defaults are widespread, banks are also lenders to many of these companies outside of CLOs (through revolvers, term loans, etc.). So they’d take losses on direct loans and see a spike in nonperforming assets. While the epicenter of the crisis might be “shadow banks” like insurance and pension funds, eventually the regulated banks could feel enough pain to spook markets about their stability too. At that point, you have a full-spectrum financial crisis.
7. Feedback to Consumers and the Economy: Finally, consider the fallout for ordinary people. If pension funds incur big losses, they may cut benefits or demand higher contributions from employers. If insurers become impaired, policyholders may worry about their claims or annuities; in worst cases, an insurer failure could delay payments to families. People nearing retirement could see the value of their portfolios and pension expectations shrink just as they need them, reducing their spending and confidence. And of course, if a credit crunch forces businesses to lay off workers en masse, unemployment rises and feeds a downward economic spiral. In a nightmare scenario, you could have a recession worsened by a “financial accelerator” effect, where financial losses (in CLOs) cause institutions to pull back, which hurts the real economy, which in turn causes more financial losses – a vicious loop, much like 2008. The Financial Stability Board has cautioned that today’s leveraged loan and CLO markets “may be more vulnerable to macroeconomic shocks than in the past, and stress in leveraged loan markets could disrupt other markets.” That’s a polite way of saying a CLO collapse could transmit stress far and wide, given the interconnections.

When the Music Stops: What Will Policymakers Do?

The policy response to a CLO-driven crisis should tackle both immediate fire-fighting and long-term fixes. On the immediate front, the Federal Reserve and U.S. Treasury would likely need to step in to provide liquidity to the corporate credit market. This could mean the Fed dusts off the emergency playbook it used in 2020: for example, back then it created facilities to buy corporate bonds and even ETFs. It could extend that to buying senior CLO tranches or accepting them as collateral for loans, stabilizing their value and reassuring investors (in fact, the Fed implicitly included AAA CLOs among assets it could buy in an emergency during the COVID crisis, though it never had to actually do it). An ideal policy would also coordinate with banks to ensure they keep lending to viable firms so that a temporary market freeze doesn’t kill otherwise healthy companies.

The government might also consider direct support to vital institutions like pension funds, if their losses threaten to impoverish retirees. This could take the form of backstop loans or using entities like the Pension Benefit Guaranty Corporation (PBGC) to absorb and restructure failing pensions (though PBGC itself would likely need a bailout in a truly large crisis). For insurance companies, regulators might temporarily ease capital requirements to prevent a forced asset sell-off, while arranging industry-funded solutions for any insolvent insurers (in the ideal scenario, with federal oversight if needed to inject funds and later recoup via fees on the industry). Essentially, you’d want to prevent a domino effect of failures.

Unfortunately, bailouts aren't an exact science, and policy makers typically take a shoot first, ask questions later approach, given the speed of financial crises. While this might make sense in the heat of battle, they tend to have unintended consequences, such as widening wealth inequality, market disruptions and inflation. After 2008 and 2020, the political capital required to preserve the system is arguably spent.

The likely response, given the current political climate, could be much more ad-hoc and hesitant. Any whiff of “bailouts” for Wall Street is politically toxic these days. In 2008, the Bush and Obama administrations pushed through massive rescues (TARP, etc.) but with great difficulty and lasting public resentment. Today, with populism on the rise across the spectrum, Washington might balk at anything that looks like a bailout of financiers.

There could be a lot of finger-pointing and denial initially – perhaps officials will say “CLOs are a niche issue, we don’t see contagion” (echoing the infamous “subprime is contained” optimism of early 2007). If stress emerged, the first instinct might be to reassure and avoid dramatic intervention, at least until things clearly spiral.

However, when push comes to shove, I suspect the Fed would quietly use its tools to prevent outright financial collapse. The Fed can act without Congress, which is key if political gridlock or backlash prevents a fiscal bailout. In a severe CLO-driven liquidity crisis, the Fed could invoke its emergency 13(3) powers to set up a funding facility for institutions holding CLOs – for example, lending against AAA CLO tranches to take the pressure off insurers forced to sell. It could even buy portions of the CLO or underlying loans via a Special Purpose Vehicle (similar to what it did with corporate bond ETFs in 2020). These would be stealth bailouts – stabilizing Wall Street indirectly to protect Main Street. The average person might not even realize it’s happening (just as many didn’t know the Fed backstopped money market funds and asset-backed securities in ’08). The likely playbook is monetary intervention first and foremost – cut rates, flood markets with liquidity, and hope that calms things. Remember, however, that while these measures were taken in 2020 and eventually helped, the S&P 500 still dropped by about 35% in the course of a month.

What about the current administration’s fiscal response? Unknown. All I can assume is that there's a high probability they make the problem worse.

The biggest wildcard is the global aspect.

U.S. CLOs have many foreign buyers, including Japanese banks and European investors. If things go south, international coordination may be needed to avoid global financial or economic collapse. The Bank of Japan or European Central Bank might have to support their banks that have American CLO exposure. We could see something akin to 2008 where the crisis transatlantic feedback loop required joint central bank actions, with the US Federal Reserve providing foreign central banks with US dollars (dollar swap lines). Given growing US isolationism, global cooperation - which is mutually beneficial, despite the rhetoric - is no longer a given.

From Financial Crisis to Economic Depression

When the dust settles, who is left holding the bag? The short answer: us, the citizens. One way or another, the ultimate risk-bearers of a CLO debacle are average people, whether as retirees, employees, taxpayers, or consumers. This is perhaps the most frustrating aspect of the whole saga. The risk was supposed to be diversified and sold off to those best able to handle it, but in reality it has concentrated in institutions that directly affect the financial well-being of everyday folks.

Consider pensions: If a pension fund suffers big losses on CLOs, the retirees and workers in that pension plan will face the consequences. That could mean cuts to future benefits, reductions in cost-of-living adjustments, or even in extreme cases, the pension plan going insolvent and being taken over by government entities (which typically leads to benefit reductions for higher earners). For public pensions (like state government employee funds), any shortfall often has to be plugged by taxpayers or by painful budget cuts (which also hurt citizens via reduced public services or higher local taxes). In every scenario, it’s essentially the public paying – either through diminished retirement income or through footing the bill to rescue the plan.

Considering the current war on the middle class via government clear-cutting basic social services, I wouldn't be shocked if pensions wouldn't get bailed out leaving retirees fending for their lives.

For insurance companies, the stakes are similarly personal. Life insurers, for example, underpin millions of annuities, life policies, and long-term care coverage. If a major life insurer were to fail because its balance sheet was wrecked by CLO and corporate credit losses, policyholders could find their life savings at risk. Government guaranty funds could step in (again TBD given the current war on basic government services) to cover some of the losses, but those funds have limits.

And how are guaranty funds financed? By assessments on other insurers – costs which ultimately filter down to consumers via higher premiums. Or, if the failure is too large, it might require a broader taxpayer-backed solution. Recall AIG in 2008: it was an insurance conglomerate that nearly collapsed from bad bets on CDOs, and it took a $182 billion federal bailout to prevent chaos. That money effectively came from taxpayers (though AIG repaid in the end, the risk was socialized). We could see a repeat in form: if multiple insurers get in trouble, the public will either bail them out or bear the losses. Either outcome means we pay.

Let’s not forget individual investors. Many 401(k) plans and IRAs are invested in bond funds, some of which could hold slices of CLO debt or the corporate bonds of companies that might default. A collapse in leveraged loans would likely spill into high-yield bond prices (those markets are cousins), so your retirement portfolio could take a hit even if you never heard of a CLO. We’re all more intertwined with this market than most people know.

There’s also a more diffuse but profound way we all bear the risk: the macroeconomic fallout. If a CLO-driven crisis causes a recession (or exacerbates one), then everyone pays in terms of lost jobs, lower wages, reduced wealth, and general economic hardship. The 2008 crisis showed how even people who never took out a subprime mortgage suffered – through a higher unemployment rate, a stock market crash that hurt pensions and savings, and a sluggish recovery that lasted years. Dubbed as the "Great Recession", the economic pain during the years after the financial crisis came second only to the Great Depression of the 1930s.

Similarly, a corporate credit bust would mean more companies failing, higher unemployment, and potential hits to the stock market, since stock investors would foresee lower profits and maybe dilutive debt restructurings. If pensions and insurers incur big losses, it could also sap consumer confidence – people might feel less secure about their retirement or coverage and thus spend less, further dragging on growth.

In the end, what was marketed as a way to distribute and minimize risk (securitize those loans! spread them around!) ends up concentrating risk in the very foundations of ordinary people’s financial lives.

It’s a bitter irony that average citizens – who have no direct say in these complex financial structures – are the ones poised to suffer the most.

Collapse2050 exists to explore life altering (or ending) risks related to the biosphere, nuclear war, resource depletion, economic collapse, and other existential threats.

My efforts are entirely reader funded. Support my research and writing by subscribing, sharing or making a one-time contribution.