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Systemic Risks Emerge in $2 Trillion Credit Market
Recent turmoil in the leveraged loan market has exposed fundamental weaknesses in the collateralized loan obligation (CLO) ecosystem, with the sudden collapse of First Brands Group serving as a stark warning to investors. The leveraged loan market faces increased scrutiny as market participants question whether due diligence has been sacrificed for speed in an environment of insatiable demand for higher-yielding assets.
The First Brands Implosion: A Case Study in Market Excess
First Brands Group, a major manufacturer of automotive components including antifreeze, windshield wipers, and brake pads, filed for bankruptcy protection just weeks after securing over $750 million in financing for acquisitions. The company’s rapid downfall has resulted in approximately $4 billion in losses across more than 80 CLO vehicles managed by prominent asset managers including PGIM, Franklin Templeton, Blackstone, and Oaktree.
According to Morgan Stanley analysis, the loans are now trading at just cents on the dollar, with the implied losses primarily impacting CLO equity holders who bear the first losses in these structured vehicles. The situation echoes concerns raised by recent executive departures in financial leadership positions, signaling potential stress in credit markets.
CLO Market Structure Under Microscope
Collateralized loan obligations have become the dominant buyers in the leveraged loan market, with these structured vehicles providing private equity firms with nearly unlimited demand for acquisition financing. CLOs typically employ significant leverage—often 10 times—with $50 million of equity supporting $500 million loan portfolios, creating thin cushions to absorb defaults.
“Inside credit markets for more than a year, there has been a grudging recognition that there was and is a series of credit problems that could be substantial and could be dangerous to the overall economy,” said Andrew Milgram, chief investment officer of Marblegate Asset Management.
Due Diligence Concerns Mount
The speed of recent leveraged loan transactions has raised eyebrows across the industry. First Brands’ March 2024 capital raise illustrates the compressed timeline: the company announced its debt financing needs on a Monday morning, and investors were allocated the loans before lunch on Friday of the same week.
This accelerated process has occurred despite some of the worst investor protections on record, according to Covenant Review. The situation bears similarities to regulatory challenges facing other rapidly expanding companies, where growth has sometimes outpaced operational controls.
Warning Signs Overlooked
Several investors who avoided First Brands debt pointed to multiple red flags that should have raised concerns. The company operated through perpetual acquisition of smaller businesses, funded by successive debt raises, making it difficult to assess underlying business performance. Additionally, discrepancies between reported profits and actual cash flows created analytical challenges.
“Everything was adjusted,” one skeptical investor noted regarding First Brands’ profit statements. “Nothing tied to cash so it was virtually impossible to analyze.”
Broader Market Implications
The First Brands collapse, following closely on the bankruptcy of subprime auto lender Tricolor, has begun to weigh on the broader leveraged loan market. PitchBook LCD data shows the US leveraged loan market is on pace for its biggest monthly loss since 2022, despite record issuance of $404 billion in the third quarter.
Bank of America strategist Pratik Gupta observed that “the two successive defaults of [First Brands] and Tricolor Auto brought into highlight potential irregularities and underwriting challenges in the credit market. The market has started to take a dim view of credit fundamentals.”
Technology and Analytical Constraints
The strain on CLO managers’ analytical capabilities has become increasingly apparent. Josh Easterly, chief investment officer of Sixth Street, highlighted that many CLO investment firms maintain only a handful of analysts covering entire credit portfolios that can include hundreds of different investments. This analytical shortfall occurs even as technology companies push advanced analytical tools that could potentially enhance due diligence processes.
Industry Response and Future Outlook
Some asset managers are already positioning themselves to distance from the fallout. Silver Point Capital recently began marketing its first euro CLO by explicitly highlighting in investor materials that “Silver Point has zero First Brands exposure.”
While defaults in the leveraged loan market remain low by historical standards, according to PitchBook LCD data, concerns are mounting about the lack of thorough due diligence in a frothy market. The situation reflects broader challenges in scaling complex financial systems while maintaining adequate controls.
As Milgram of Marblegate summarized: “With [Tricolor] and First Brands, the problems of the credit market are starting to percolate into the general Wall Street psyche. Are we entering a period where those [CLO market’s] assumptions will be tested?”
The coming months will reveal whether First Brands represents an isolated failure or the beginning of a broader reassessment of risk in the $2 trillion leveraged loan market, with potentially significant implications for corporate borrowing costs and private equity activity.
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