The Externalities of Fire Sales: Evidence from Collateralized Loan Obligations

95 Pages Posted: 24 Nov 2020 Last revised: 17 Sep 2021

See all articles by Shohini Kundu

Shohini Kundu

University of California, Los Angeles (UCLA) - Anderson School of Management

Date Written: September 17, 2021

Abstract

This paper investigates how covenants, intrinsic to Collateralized Loan Obligation (CLO) indentures, provide a mechanism through which idiosyncratic shocks may amplify, imposing negative externalities on other unrelated firms in CLO portfolios. Exploiting cross-sectional variation in firms' exposures to the Oil & Gas (O&G) industry through CLOs, as well as the timing of the O&G price plunge in 2014, I study how non-O&G firms in CLO portfolios are affected. When CLOs are subject to idiosyncratic shocks that push them closer to their covenant thresholds, they fire-sell unrelated loans in the secondary loan market to alleviate their constraints. These fire sales exert price pressure across security markets. The market dislocations erode the liquidity positions of exposed firms, spilling into real economic activity. Contrary to traditional fire sale settings, I find CLOs fire-sell loans issued by riskier firms for contractual arbitrage purposes -- exploiting loopholes in the design of covenants. The sample period for this study is 2013-2015, a relatively benign macroeconomic period. However, the results suggest the effects may be larger during times of stress, including the outset of the COVID-19 pandemic.

Keywords: covenants, contracts, fire sales, externalities, CLOs

JEL Classification: E44, G23, E32

Suggested Citation

Kundu, Shohini, The Externalities of Fire Sales: Evidence from Collateralized Loan Obligations (September 17, 2021). Available at SSRN: https://ssrn.com/abstract=3735645 or http://dx.doi.org/10.2139/ssrn.3735645

Shohini Kundu (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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