Zero Hedge

Some of the primary culprits for the credit bubble, created part and parcel with the ubiquitous spread of the securitization product, were the alphabet soups of assorted collateralized asset pool funds such as CDOs, CMOs and, most notably, CLOs. A week ago Zero Hedge wrote about the increasingly prominent position of CLOs in the crosshairs of rating agencies, when Moody's put all non-AAA CLO tranches on downgrade review. The action impacted funds holding about $440 billion in assets. Today Bloomberg picks up on this topic presenting several very dire predictions of what the ongoing drubbing in less than pristine CLO tranches means for many funds. In summary, quoting Ross Heller of NewOak Capital:

"The game is over. There isn’t going to be money available for refinancing. Companies will have to be put into bankruptcy and the debt restructured."

And Zero Hedge is called pessimistic. But what are the facts: leveraged loan issuance in the U.S. plummeted to $11.7 billion in January and February from $66.3 billion in the first two months of 2008 and $158.7 billion for the same period in 2007: investors are busy offloading existing loan holdings as both the HY and LCDX indexes continue probing new lows.

A little background per Bloomberg:

CLOs, a type of collateralized debt obligation, pool below investment-grade loans and slice them into securities of varying risk and return. The leveraged loans are rated below BBB- by Standard & Poor’s and less than Baa3 at Moody’s and are defaulting at a 4.5 percent rate, the fastest since November 2002, according to data from S&P’s LCD.

Now, as an economic slowdown drags into the 16th month, borrowers unable to pay their debts are causing record losses for CLOs. Moody’s Investors Service put 760 of the funds, holding about $440 billion of assets, on review for downgrades on March 4. Unless policymakers decide to earmark some of the $11.6 trillion of government programs created to combat the seizure in credit markets to support high-yield loans, defaults may soar through 2012, according to investors.

The market began to unravel in July 2007, just as bankers tried to find investors for credit they provided in KKR’s 11.1- billion-pound ($15.6 billion) purchase of Alliance Boots Holdings Ltd., the owner of Britain’s biggest drugstore chain. Deutsche Bank AG, JPMorgan Chase & Co. and other banks were forced to delay selling 8 billion pounds of loans for the takeover, becoming the first deal frozen when credit markets started to seize up.

Lower loan prices and companies reneging on their debt agreements are causing losses on the CLO securities held by banks, insurance companies and hedge funds.

Additionally, CLOs holders of less than pristine tranches will not benefit from any of the government's subsidy programs (most notably TALF), which as ZH wrote, focuses only on the top-most, AAA rated tranches, which for all intents and purposes are not in significant danger: it is the lower rated tranches that need incremental capital.

“CLOs should be the next focus for the TALF,” said Randy Schwimmer, a senior managing director of Churchill Financial LLC in New York, a lender that also manages more than $3 billion of the debt pools. “Commercial lending needs to be supported.”

Without demand from CLOs, companies are paying higher rates for loans, Schwimmer said.

Investors bought CLOs because they had higher returns than similarly rated securities. The $58 million AA ranked portion of KKR Financial CLO Ltd. sold in March 2005 offered investors interest of 45 basis points more than benchmark bank rates. That compared with a spread of as little as 36 basis points for companies of the same grade, according to Merrill Lynch & Co. indexes. A basis point is 0.01 percentage point.
As cash flowed into CLOs, the funds bought almost two-thirds of the debt that financed the record $616 billion of leveraged buyouts in the first half of 2007, S&P LCD data show. Between 2002 and 2007, they accounted for 60 percent of term loan purchases, according to S&P LCD.
Until the credit markets seized up in late 2007, private equity firms, including Blackstone and Carlyle Group, formed teams to manage CLOs. They earn revenue by charging fees and buying stakes in funds they oversee.

“They opened up the buyer base and enabled leveraged finance debt to be purchased by the far-larger investment-grade universe,” said Chris Taggert, an analyst at debt research firm CreditSights Inc. in New York.

And like every drunken orgy, this one is now in a world of hangover pain.

A return of the CLO market is unlikely because the existing securities have lost so much value, said NewOak’s Heller, who doesn’t agree that the government should support the high-yield debt.

With the average CCC ranked loan quoted at 36.5 cents on the dollar, 147 of 557 CLOs monitored by Wachovia Corp. are violating terms requiring a minimum amount of collateral.

Breaking these rules may force managers to shut payments off to the riskiest portions of the fund and divert cash to repay the safest bonds, Heller said.

Four of KKR’s CLOs holding about $7 billion of loans are breaching this test and paying down senior notes, according to a regulatory filing by the New York-based firm March 2. KKR spokesman Peter McKillop declined to comment.

If company downgrades to the lowest ranks reach 40 percent, managers will have to dump holdings, further depressing loan prices, according to Kyle Bass, the managing partner of Dallas- based Hayman Advisors, who made $500 million in 2007 betting on losses from subprime mortgages.

“The unintended and dangerous consequence of these defaults would be an evaporation of the CLO bid,” Bass wrote in a letter to investors this month. “Now is not the time to enter this space.”

The bottom line is that all those who claim that deleveraging is done, have no idea what they are talking about. While the Moody's Death Watch list accounts for a little over $200 billion, thanks to the greed of packaging and securitizing leveraged loan, the world is facing near half a trillion in defaults as the market for CLOs disappears, and the only bidders remaining are those laser-focused on specific names, and usually with Investment Grade ratings. And the last thing to keep in mind is that CLOs are not alone: a default wave among the CLO pool will promptly drag with it all other forms of securitization, whose current interdependent existence is balanced more precariously than a house of cards on the head of a pin.

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