Are CLOs the next financial risk? Comparing today’s leveraged-loan boom with the CDOs of 2008
Collateralized Debt Obligations (CDOs) were indeed one of the major causes of the Great Recession of 2008, although not the sole factor.[1]
The role of CDOs was central to the crisis:[2]
- Asset Type: Many pre-2008 CDOs were heavily reliant on subprime mortgage-backed securities (MBS) as their underlying collateral.[3] Subprime mortgages were issued to borrowers with poor credit, making them inherently risky.[4]
- Risk Masking: The CDO structure allowed risky subprime MBS to be pooled, sliced into different risk tranches (senior, mezzanine, equity), and then sold.[5] The most senior tranches were often given undeserved AAA credit ratings by rating agencies, masking the true risk and making them appealing to banks, pension funds, and other institutional investors seeking safe, high-yield investments.
- Domino Effect: When the U.S. housing bubble burst, a wave of homeowners defaulted on their subprime mortgages.[6]This caused the value of the underlying MBS to plummet, leading to massive losses for investors holding the lower tranches of the CDOs, and eventually impacting the supposedly safe, higher-rated tranches as well. The resulting panic and freeze in the credit markets precipitated the wider financial crisis.
CLOs and the Next Recession
Whether Collateralized Loan Obligations (CLOs) will cause the next recession is a subject of ongoing debate among economists and financial experts. While they are a growing part of the financial landscape, their structural differences from the problematic CDOs of 2008 suggest they may be more resilient, though not without risk.[7]
Arguments for Concern (The Risk)
- Growing Leverage: The underlying collateral for CLOs is leveraged loans (loans to non-investment-grade corporations), often facilitated by private equity firms for buyouts.[8] The sheer volume of corporate debt has risen significantly, and a major downturn could lead to widespread corporate defaults, which would test the CLO structure.
- Deteriorating Loan Quality: Some experts worry that the massive demand for leveraged loans to back CLOs is leading to a deterioration of lending standards (often referred to as “covenant-lite” loans, which offer less protection for lenders).[9]9 This mirrors the relaxed standards seen in the subprime mortgage market before 2008.
- Active vs. Passive: While CLOs are actively managed, managers may not be able to fully mitigate risks if the default rate spikes dramatically across the corporate sector.
Arguments Against Concern (The Resilience) - Different Collateral: Unlike the CDOs of 2008, CLOs are backed by corporate leveraged loans, not high-risk residential mortgages.[10] Corporate loans are typically senior secured debt, meaning they have a priority claim on the borrower’s assets in bankruptcy, leading to historically higher recovery rates than those of subprime mortgages.
- Tested Structure: CLOs performed significantly better than CDOs during the 2008 crisis and the COVID-19 downturn. The senior-most (AAA) tranches of CLOs issued between 1994 and 2009 had a near-zero default rate.
- Structural Safeguards: CLOs have built-in tests, like overcollateralization tests, that divert cash flow from junior to senior tranches if the value of the underlying loans deteriorates, offering a stronger defense against losses for high-rated investors.
- Transparency and Data: The leveraged loan market has decades of default and recovery data, allowing for more reliable risk modeling than the nascent subprime mortgage market had in the early 2000s.
CDOs vs. CLOs: Similarities and Differences
CLOs are technically a type of CDO (Collateralized Debt Obligation), but the term CLO has become distinct due to the specific nature of their collateral and their structure post-2008.
Similarities and differences
References:
[1] Unpacking CDOs: Understanding the Complex World of Collateralized Debt Obligations – C-Suite Strategy
[2] The Story of the CDO Market Meltdown: An Empirical Analysis – Harvard
[3] Were Collateralized Debt Obligations (CDOs) Responsible for the 2008 Financial Crisis? – Jul 14, 2022, Investopedia
[4] The Return of CDOs: Is Another Economic Crisis on the Horizon?– Oct 20, 2023, Business News Daily
[5] Recession and CLOs – Jul 4, 2019, Rabobank.com
[6] How CLOs are changing and why they’re resilient and buoyant – May 11, 2022, vistra.com
[7] CLOs vs. CDOs: Understanding the Difference– Aug 18, 2025, Vaneck
[8] Collateralized loan obligations: could these obscure products cause the next global financial crisis – Synovus
[9] Understanding Collateralized Loan Obligations (CLOs)– Jul 23, 2025, Guggenhe Investments
[10] CLOs vs. CDOs: Understanding the Difference – YouTube
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