Collateral crisis

Collateralised loan obligations

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The collateralised loan obligation (CLO) market is coming under pressure. A range of disparate factors are bearing down on the European and US markets, and some participants believe the massive growth posted over the past two years will not be repeated in 2007. Fears about US credit quality, combined with a glut of new supply, has dampened investor enthusiasm for CLOs in the US, while the frenzied bid for loan assets has driven spreads tighter in Europe and made it increasingly difficult to make deals work from an economic viewpoint.

After the US subprime market began to deteriorate in February, CLOs initially enjoyed a flight-to-quality bid as investors bailed out of collateralised debt obligations (CDOs) backed by mezzanine asset-backed securities (ABSs). Spreads on AAA CLO tranches tightened in a few basis points to the low-20bp level, both in Europe and the US. Banks, in turn, sprung on this increased interest from investors. Twelve new deals totalling EUR6.1 billion priced in Europe in March, while 20 CLOs worth $9 billion came to market in the US, according to research from Dresdner Kleinwort.

However, this massive volume of new issuance has had a knock-on effect on pricing in the US. Spreads on BBB tranches of US CLOs widened out from around 150bp in mid-March to approximately 200bp at the beginning of April.

At the same time, banks have started to hedge their CLO pipelines in response to growing concerns about credit quality. This follows the problems in the US subprime market in February, when a rise in delinquencies caused spreads on CDOs of mezzanine ABSs to widen sharply. As a result, a number of investment banks warehousing ABS assets suffered losses (Risk April 2007, pages 42-44).

"After what happened with the subprime market, a lot of risk managers were berated for not doing their jobs and hedging out CDO warehouses, particularly those that had exposure to subprime and mezzanine bonds," says Laila Kollmorgen, head of ABS/MBS/cash CDO trading at BNP Paribas in London. "As a result, they're taking a look at all their CDO warehouses, whether the exposure is coming from leveraged loans or high-grade deals, and they're saying 'OK, hedge'."

As well as using the iTraxx crossover index and credit default swaps (CDSs) on loans, some banks are using CDSs referencing BBB and BB CLO tranches to hedge their exposures. These instruments are extremely illiquid and currently trade significantly wider than cash CLO tranches. This discrepancy has, to some extent, helped push cash spreads closer to the synthetic levels - a phenomenon that has been most pronounced in the US.

"The CDS is being bid wider than cash, so the cash starts to go wider because real-money investors think, 'Why would I want to buy BBB or BB when I can sell protection at a wider level?'" explains Kollmorgen. "It's almost a self-fulfilling prophecy, where dealers and arrangers are looking to hedge out their future issuance pipeline. Their risk management department is telling them to bid CDSs, so they're bidding the CDSs wider than where the cash is printed in order to get interest, and then the cash investors say 'if that's where there's interest, the cash needs to go wider'."

This imbalance between cash and synthetic is likely to persist as banks take a cautious approach to credit, and protection buyers continue to dominate the CDS of CLOs market. Further new CLO issuance is also expected before the end of the second quarter, which could put further pressure on spreads. The upshot is that new deals will be more expensive to bring to market, while increased funding costs will make it more difficult to execute transactions from the issuer's perspective. Kollmorgen expects the US market to slow, with the possibility of another wave of issuance towards the end of the year.

In Europe, a different set of factors is affecting CLOs. But it could lead to the same end result - a slowdown of the market. The sector has got off to a good start this year, with EUR8.2 billion of paper priced in the first quarter. The market has largely been immune to spread widening, but investors are becoming more choosy. "There have been a large number of deals in the market and the spread widening we have seen at the BBB and BB levels over the past month or so is down to, we believe, oversupply. The deals that have widened the most have tended to be from new managers," says Richard Huddart, structured credit analyst at Dresdner Kleinwort in London.

Those managers outside the top tier and considered to be the poorest performers have also seen their spreads widen. "Everyone says the market is widening.Well, it isn't really," says a London-based CLO manager. "It is really just the seven or eight managers that no-one wants to buy and, quite frankly, shouldn't be allowed to manage CLOs."

Of most concern to European CLO managers and investors is the quality of the collateral and the availability of underlying loan assets. "The loans going into these vehicles at the moment is probably of a higher risk than what was going into them a few months ago," says Sara Halbard, London-based head of European CDOs at ICG, part of Intermediate Capital Group, a mezzanine financing provider. She points to the emergence of 'covenant-lite' loans as being of particular concern to some participants. Covenant-lite structures lack many of the usual restrictions available on normal loans, such as limits on maximum leverage, reducing the protection for lenders.

Stretched

"Because the underlying structures are more stretched and we've had this covenant-lite issue floating through the market, investors are looking at these trends and the loosening of credit standards in the US subprime market that caused the blow-up and are drawing parallels," adds Halbard.

Despite the concerns about credit quality and loan structure, the bid for loan assets in the European market remains very strong - a result of the continued demand for loans from CLO managers and hedge funds. At the same time, prepayment rates have picked up sharply. Prepayment occurs when a borrower seeks to repay or refinance a loan. What this means for CLO managers is that one of their assets suddenly disappears from the collateral pool, forcing them to replace it with an asset paying an equivalent spread. But finding assets at wide enough spreads to generate sufficient returns within CLOs is proving tricky.

"Prepayment rates have been high, so managers probably have unusually high cash balances," says Halbard. "That's going to have an impact on returns, particularly for equity investors, because managers haven't been able to reinvest fast enough in assets with a comparable spread to what they've been prepaid on."

High prepayment levels have a secondary effect on CLOs. The universe of loan assets is extremely limited. That means CLO managers forced to replace prepaid loans are ending up with portfolios of very similar assets. "The CLO investor space has grown considerably over the past year or two, and one of the issues to have received a lot of attention recently is name overlap," says Dresdner's Huddart. "If you're investing in a lot of different European managers, then you should pay close attention to the managers' strategies in order to ensure you are happy with the diversification in the aggregate global reference portfolio to which you are exposed."

One way investors have avoided the overlap issue is by diversifying investments across different vintages. However, high prepayment rates mean managers have little choice but to look to the current universe of assets to replace older vintage loans that have prepaid. "Two or three years down the line, deals will begin to look increasingly alike as loans are prepaid and portfolio managers are forced to replace them," explains Huddart.

If the loan spreads reduce any further, managers say it will be difficult to put deals together that work economically. "If spreads go down any further, we will see the first CLOs breach their spread tests," remarks the CLO manager. "Then they will all start imploding. That is actually the key risk for 2007 because a CLO can't function with senior loan spreads at 200bp."

In the primary market, the ability to price deals will hinge on managers' ability to deliver sufficient equity returns. "The key driver of all this is going to be the economics of the deals, and that comes down to equity returns," says Huddart. "Unless the equity investors are going to get the hurdle rate they need to take on the first loss risk, then deals are not going to print."

As well as the strong bid for loan assets from CLO managers and hedge funds, some participants suggest the loan credit default swap (LCDS) market is also putting pressure on spreads. Although a small and relatively illiquid market, demand from investors seeking access to the leveraged loan asset class is forcing spreads in the European LCDS market tighter than the underlying cash loans. When private equity sponsors observe where these loans are pricing in the LCDS market, they are requesting that banks re-price their loans at tighter levels. "Some aggressive banks are doing this because they know they can hedge themselves at tighter levels then they're making the loans," says the London-based CLO manager.

Huddart believes loan spreads will find a floor at the levels needed to reach the hurdle rates for equity investors. Nonetheless, some experienced CLO managers are taking a much more cautious approach to the market. In fact, some are stepping back and waiting for conditions to stabilise before launching new deals.

"We've been going for a reasonable time and we've got scale," says ICG's Halbard. "If we don't do a deal this year or in the next 18 months, it's not going to affect our business."

But not all managers have that luxury. New entrants in particular may not be able to take a break from the market. Managers with one or two deals under their belts need to reach critical mass to make their business model work. The fixed cost base of conducting CLO business is high, and managers need a critical mass of $1.5 billion-2 billion in funds under management, say dealers. The prospect of not being able to do that second or third deal could mean they are put out of business.

"Some may be forced to do deals, some may realise that Europe was a little more challenging than they thought and give up," says Halbard. "Some of the smaller boutiques in Europe will struggle on for a while and some will eventually wind up and close up shop."

Struggling

In fact, smaller managers are reported to be struggling already. According to one CLO manager, banks are getting very nervous about the mandates they've taken on, especially with first-time managers. In addition, the CLO market is awash with rumours about first-time managers having to unwind their warehouses because they can't ramp up deals.

"Tightening leveraged loan spreads are pressuring CLO economics somewhat," says Dresdner's Huddart. "Now could be a challenging time for new managers to launch new deals, as they typically fund their CLO notes at a premium to their more established counterparts."

Those on the sidelines are not sitting idly, however. Firms active in managing loan assets are increasingly turning to credit opportunity funds, which allow managers more flexibility in their funding structures and give them the ability to use leverage. Carlyle Group, which manages EUR2.8 billion in European CLOs, launched a credit opportunities fund last year to tap into flexible funding as markets become more difficult (Risk May 2007, page 33). Others are set to follow suit.

"We're looking at more flexible funding structures because if a hedge fund manager gets 30 times leverage, maybe we should be looking into that as well," says the London-based CLO manager. "I think you are going to see some convergence between CLO managers and hedge fund managers, as well as the emergence of more flexible funding vehicles that don't involve rating agencies, such as credit opportunity funds."

Other loan structures have also debuted recently. Calyon, for instance, launched a EUR2.6 billion multi-manager vehicle called Confluent last year, managed by Credit Agricole Asset Management (CAAM) (Risk November 2006, page 72).

The structure allows the multi-manager to allocate cash to five sub-managers, which invest their share of the deal in leveraged loan assets within certain risk concentration constraints - for instance, limits on individual names, industries and geographies at both the aggregate portfolio level and the sub-manager level. The sub-managers' performance is monitored on an ongoing basis and CAAM can choose to reallocate cash from one sub-manager to another or potentially remove poor-performing sub-managers.

"It's the best product in terms of the loan environment, and the market value features perform extremely well with the loan asset class," says Loic Fery, global head of credit and CDO markets at Calyon in London. "Confluent proves you don't need to do a CLO per se, and with this type of multi-managed market value loan deal we emphasise that loans are the most stable asset class in terms of market value price."

Calyon has teamed up with Newport Beach, California-based fixed-income asset manager Pimco to structure another Confluent-type deal, which Fery expects will be around EUR2.5 billion-3 billion in size. A further similarly sized deal is also possible from Calyon and another multi-manager, to be announced later in the year.

CLO managers and other market participants agree the road ahead is going to be a tough one for both the European and the US CLO markets. Whereas the issues in the US largely revolve around concerns over credit quality, Europe's problems are more fundamental - there is an insufficient supply of loan assets to meet demand. The flood of new managers has exacerbated this problem over the past 18 months.

"This was inevitable," remarks Halbard. "It's been a catalyst for the investors on the other side of the trade to just take a step back and say, 'wait, maybe this isn't quite so great and maybe we ought to be a little cautious'."

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