The $250 billion question

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.

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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.

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