The news from leveraged-loan land has been particularly dismal of late: Prices in the secondary market have plunged to record lows, and expectations of a severe recession are spurring worries of record corporate defaults. Fear is rising that the collateralized loan obligation funds that fueled the surge in leveraged lending before the credit crunch could soon be in trouble.
"We've left the zone of rationality," says one leveraged finance banker. "There's an utter lack of demand, and there's no playbook here." The banker is referring to the record low of 66.05% of par value hit on Oct. 17 by the most liquid loans as measured by Standard & Poor's Leveraged Commentary & Data. These are senior, secured loans, meaning they sit atop the borrowers' capital structure and are the first to be paid in the event of default. In more normal times, it's rare for such loans to trade much under par.
But the market said goodbye to "normal" some time ago. S&P asserts that current prices imply unheard-of default rates of these securities. If that's true, it could mean trouble -- more trouble -- for banks that have invested a combined $250 billion in loan investment vehicles.
Continue reading below
How much trouble is the big question. For now, loan markets are
being depressed by a surge in forced sales of portfolios by struggling
hedge funds and CLOs. According to LCD, the amount of such sales this
month, referred to as "bids wanted in competition," or BWICs, hit $2.31
billion as of Oct. 20. That's already the highest monthly total since
S&P began tracking the data last year. For the year so far, BWIC
volume totals $9.04 billion, up from $8.9 billion for 2007.
"The spike in BWIC activity is both a symptom and a cause of the
loan market's woes," wrote LCD in a report, comparing the forced
selling with the overhang of unsyndicated loan commitments on banks'
books that choked the market last year. That overhang was once as high
as $300 billion but has now dwindled through a combination of fire
sales and busted deals to less than $50 billion. "The ongoing sales
have kept prices under pressure. What's more, concerns that BWICs will
continue to flood the market with supply are keeping bargain hunters at
bay," LCD adds.
Sales of loan portfolios are coming from firms such as Highland Capital Management LP, GoldenTree Asset Management LP and Citadel Investment Group LLC.
Those funds have been losing money as the value of loans has tumbled.
The Wall Street Journal reported on Oct. 23, for example, that Bain Capital LLC's
Sankaty Advisors LLC credit affiliate has lost fully half its value
from loan price declines. A similar dynamic, sources say, is playing
out with market-value CLOs, which are beginning to unload loans as
falling prices set off market-value triggers.
Market-value CLOs and hedge funds -- both mark-to-market vehicles --
hold about $50 billion in loan volume. That number represents just over
10% of the total $475 billion held by all investment funds in the
market, according to J.P. Morgan Chase & Co. research.
But short-term market gyrations won't hurt the majority of investors
in leveraged loans. That's because the bulk of the investment vehicles
in the sector are so-called cash flow CLOs, which do not mark their
portfolios to market and consequently aren't as vulnerable to market
volatility. Instead, they hold the loans at par value and continue to
pay their investors as long as defaults don't disrupt the flow of
interest payments that generate returns as they cascade down through
the various CLO tranches.
"No one has ever lost money in a triple-A CLO investment," argues one banker.
However, the prospect of rising defaults could become a real worry for these funds.
For now, default rates remain low compared with the historical
average of 4.35%, but the trend is unmistakably bad: According to
S&P data, global default rates for the 12 months ended in September
hit 2.04%, up from 1.84% in August. In the U.S., speculative-grade
defaults ran at 2.68% in September, up from 2.44% in August. That
figure is almost triple the record low 0.95% default rate at the end of
2007.
And, of course, the outlook is much worse. S&P says it expects
defaults to jump to 7.6% in the next 12 months and, "under a
pessimistic scenario," could reach 9.6%. That number is still below the
historic high of 12.5% hit during the 1991-1992 recession, when the
high-yield market virtually shut down. But the market is reacting much
more pessimistically than S&P. Indeed, the default rate implied by
current loan market prices is 23.4%, according to LCD. In other words,
the market is suggesting that almost a quarter of current leveraged
borrowers could default before their debt matures.
If that happens, it could present problems for investors in the
vehicles, particularly for banks, which are the largest buyers of the
most secure triple-A tranches of CLOs. J.P. Morgan estimates that
commercial banks, mostly from Europe, hold about $250 billion of
investments in the most senior, and presumably most secure, tranches.
The banks were active investors in the structures during the credit
boom. They also inherited large triple-A CLO investments from the
formerly off-balance-sheet structured investment vehicles that banks
largely took back on their balance sheets when the credit crisis began
last year. Those SIVs were by far the largest investors in triple-A CLO
tranches, at one point representing some 50% of senior investments in
the loan vehicles.
Consequently, any large-scale rise in default rates that cuts off
the flow of funds to the vehicles, resulting in losses, will presumably
hurt bank balance sheets at a time of extreme vulnerability.
However, loan market participants caution that such an outcome,
though not impossible, is still highly unlikely. The reason: CLOs were
structured to avoid massive default risk.
First, the vehicles are overcollateralized, meaning the value of
bonds backing the CLO is higher than the CLO's value, allowing for some
cushion to protect investors. Second, senior loans are backed by hard
assets, which will allow for some recovery if companies begin to fail
in a recession. Third, investors feel protected because, unlike the
pool of mortgages backing the infamous CDOs that started the crisis,
loans are spread out among industries, creating protection through
sectoral diversification.
"At some point, this stuff does have intrinsic value," says one investor.
Of course, cash flow CLOs have never been tested in a market
environment as gruesome as this. How well they handle things from here
on out remains the $250 billion question.
