CLOs: “the mass unwinding is up for debate”
Monday, November 3rd, 2008
Corporate leveraged loan market braced for further hardship
By Nicole Bullock in New York
Published: November 3 2008 19:16 | Last updated: November 3 2008 19:16
The unwinding of the investment vehicles that drove the credit boom is roiling the once-staid corporate leveraged loan market, and the pain may not be over yet.
For years the US loan market was a clubby world dominated by banks, insurance companies and a few mutual funds.
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In the early part of the decade steady returns, low defaults and high recovery in bankruptcy attracted new buyers that used leverage to boost returns.
Now these vehicles are unravelling in a wave of selling that is causing and feeding on volatility in the asset class.
“We expect market volatility around loans to continue to cause these structures to delever and add further pressure to the market,” analysts at Barclays Capital said in a recent research report.
Among the investment vehicles that bought loans were collateralised loan obligations (CLOs) and total return swaps (TRSs).
Barclays estimates that the two bought 80 per cent of new US loans issued from 2003 to 2007.
CLOs are a type of securitisation where loans are pooled and income paid out via tranches of varying credit risk.
Similar to a margin call, some CLOs, called market value CLOs, contain triggers that force managers to sell assets or post additional collateral should the price of the underlying loans fall beneath a certain level.
So-called cash CLOs, the majority of the group, have triggers based on default rates and credit quality.
TRS programmes are derivatives where parties swap payments based on a set rate and payments based on asset, in this case, the loan.
In October, more than $3bn in loans were put on the auction block as market value CLOs and TRS programmes unwound, according to Standard & Poor’s Leveraged Commentary & Data, which tracks the loan market.
Average loan prices fell to just under 70 cents on the dollar, S&P LCD data show.
Prior to October, loan prices had never slipped below 80 and they dropped to a low of 66 on October 15.
Steven Miller, managing director of S&P LCD, estimates that up to $50bn in market value CLOs and TRS programmes exist.
The amount that still is likely to be unwound, while problematic for the market, is much less since more recent programmes were structured with less aggressive leverage amounts and others are being restructured now instead, Mr Miller said.
Cash CLOs are a potential problem in the worst case scenario of a protracted recession that would send default rates soaring into the mid-teens.
As of the end of October, the US loan default rate still was a modest 3.59 per cent, S&P LCD data show, with consensus estimates for a rise to the high single digits next year.
For now, though, loan prices may have reached a level where investors and arrangers calculate it is too cheap to merit selling.
“Prices have fallen too quickly,” Mr Miller says. “There is a focus on forbearance. At this point, you might as well hold on. There might be more unwinding, but the mass unwinding is up for debate.”
Copyright The Financial Times Limited 2008
http://www.ft.com/cms/s/0/f5fe776c-a9d5-11dd-958b-000077b07658.html
