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— Follow the Money —
As with most things in this seemingly unending credit crunch, the problem lies with leverage or, rather, the lack of it. CLOs are structured vehicles that borrow money to invest in pools of debt. They make money by collecting the difference between the interest they collect on the debt they buy and the interest they pay on the money they borrow.
In the same way as the collateralized debt obligations that fueled the subprime boom, CLOs are tranched structures, with triple-A lenders receiving the most protection, mezzanine lenders somewhat less and equity holders the least, albeit with potential for the most gain. During the credit boom, lenders who put money into triple-A tranches charged as little as LIBOR plus 25 basis points, which allowed CLO managers to demand from corporate borrowers interest as low as LIBOR plus 150 basis points, even for the most highly leveraged and, hence, riskiest, credits. The 125-basis-point difference flowed through the CLO, from the seniormost tranches through the mezzanine pieces, ending up with equity holders; they produced hefty returns, given their 8 to 12 times leverage. No longer. Now, the seniormost investors in CLOs are asking for interest between LIBOR plus 120 to 160 basis points. While that's offset by higher rates being charged on corporate debt, sometimes as high as LIBOR plus 400 basis points, returns have come down because there's half as much leverage going into the vehicles as before. In fact, Randy Schwimmer, head of capital markets at Churchill Capital, says that most equity investors in CLOs -- they are most at risk, but also stand to make the most from the vehicles -- can expect returns in the 6% range for their investments. "That still sucks," he says. While 6% may not seem so bad, especially compared with a 2% federal funds rate and a declining stock market, there's a heightened perception of risk associated with structured products after the CDO mess. Consequently, the appetite for CLO investment has dried up. Standard & Poor's Leveraged Commentary & Data notes that the forward pipeline of CLO issuance is a measly $1.4 billion as of July 1, the lowest since S&P started tracking the data in 2005. So far this year, 23 CLOs worth $11 billion have been created, compared with 106 CLOs worth $58.8 billion for the same period last year. Of course, a lack of buy-side demand is not helping underwriters clear the loans off their books. Syndicating banks for Clear Channel's debt ran into resistance when they attempted to offload a $3 billion tranche of a $15 billion loan package. The banks had been asking for 90% of par but received bids in the low 80s, indicating very low interest. Bloomberg reported on July 1 that the banks reacted by lowering the price to the mid-80s range. Schwimmer notes that there are signs that CLO managers are becoming more inventive. Facing a moribund loan market, some have started to range further afield. In fact, he says some of the largest CLOs, such as Gulf Stream, Aladdin and Octagon, have received permission from shareholders to search for alternative assets, outside of loans. "They're looking at other ways to get value," he says, noting that distressed debt offers one potential avenue for investment, as does mezzanine debt. One capital markets source argues, however, that worries over CLO performance have been overdone. "No one's lost money by investing in a CLO," he says, since they are not marked to market and, as long as they don't default, they continue to amass interest and generate returns. However, defaults could trigger convulsions in the CLO market, as borrowers that can no longer meet interest obligations force investors to take losses. While defaults remain low, few expect them to stay that way. "We're early in the game," Schwimmer says. "Very early." |
As difficult as things have been for sellers in the leveraged loan markets recently -- witness the problems banks are having offloading $3 billion in Clear Channel Communications Inc. loans -- things are no easier for buyers. Some are even suggesting that the buy-side model that has propped up the loan market in recent years, namely, the collateralized loan obligation fund, is fundamentally broken -- at least, for now.
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