The cost of protecting corporate bonds from default is at a record, as nervous investors purchased credit default swaps to hedge against mounting losses in the US$2 trillion market for CDOs (collaterised debt obligations).
The same fears are evident in the $44 billion market for CPDOs, (constant proportion debt obligations). CPDOs package indexes of credit default swaps. Both are doubtful securities, which are losing value virtually every day, and only the foolish would ignore the ominous signs.
On February 21 2008, the iTraxx Europe index of investment grade credits was pricing a default-rate over five times higher than the highest recorded in the past 50 years, according to BNP Paribus calculations.
If you add the signs of deep concern when the once mighty KKR buy-out group is seeing its listed mortgage investment affiliate KKR Financial, 12 per cent owned by the parent, unable for the second time to repay commercial paper backed by more than $3 billion of mortgages in its portfolio, investors get even more jittery. KKR Financial’s share price has fallen 50 per cent over the last year, and more share price slides seems inevitable.
How could anyone in the credit markets have any confidence left, when Switzerland’s second largest bank, Credit Suisse owned up to $2.85 billion of losses on structured credit positions caused partly by “pricing errors” by some of its traders. If the “professionals” in the bank can’t get it right in valuing its securities, what hope is there for anyone else?
In the alphabet soup of acronyms in structured securities, CLOs (collaterised loan obligations) are in difficulties. Unlike CDOs, which are debt securities consisting of layers (called tranches) of good and bad debt wrapped together, the $350 billion CLO market is the heart of the leveraged loan market. CLOs are packages of leveraged loans sold by investment banks to hedge funds and institutions.
In 2006 and the first half of 2007, when credit was easy to arrange, pension funds and hedge funds eagerly lined up to purchase higher yield securities from marauding buy-out firms, indifferent to how risky these securities really were. Apart from CLOs, the investors were swamped with PIK (payment in kind) toggle loans. These allowed the buy-out issuers the ability to skip interest payments, when cash was tight, in exchange for a higher interest rate (usually three quarters of a per cent) on what was skipped.
The greedy investors in their stampede for the higher income return were also encouraged to take up Second Lien loans, which were used in leveraged buy-outs to fill small gaps between financing the needs of the buy-out firms and maximum thresholds measured by leverage of senior loans and mezzanine loans. There were also the dangerous covenant lite loans. And if the investors wanted to bet the ranch, they could take up the relatively larger mezzanine loans, usually unsecured, with a maturity usually exceeding five years with the principal payable at the end of the loan term.
No one in their right mind would take these risky investments to-day, but only two years ago, they were eagerly snapped up. It is hard to feel any sympathy for these greedy fools, but I suspect there are a large number of them sulking in the wings still counting out their losses.
Currently there is an overhang of at least $160 billion of leveraged loans that are the results of past deals, but contain “structural issues” (whatever they are), that just won’t allow them to be completed. You can gather how messy the current situation has ended up.
The result is more losses in the portfolios of banks and other “sophisticated” investors. One wealth management firm says more commonly traded securities have been marked down to 80 to 85 cents on the dollar, and that threatens new lending. At least someone has some sense!
The same source said that there are secured loans to ordinary middle market American companies that might have been offered at 80 to 85 cents, but now “marked down to 70 cents.” The institutional investor with a sense of humour stated the obvious: “of course no one is going to originate credit that’s worth 70 cents immediately on the dollar.”
Switzerland’s two largest banks, UBS and Credit Suisse in mid February announced the write-down of a combined $400 million in the value of leveraged loans as part of their 2007 fourth quarter earnings. Deutsche Bank, Germany’s largest bank announced write-downs of$1.11 billion.
So far the biggest loser in the bank loss race belongs to Citigroup, which hasn’t yet reported on its near $43 billion of leveraged loans, and all eyes will turn eagerly to it when it finally reports.
In the secondary market, there are margin calls, while CLOs risk hitting triggers that require asset sales, because their underlying collateral is falling in value.
The credit rating agency Fitch reported on February 7 2008 that both leveraged loans and CLOs will continue to under perform through the year. “As with all structured finance vehicles, CLO performance is inextricably linked to the performance of underlying collateral. As such, CLOs are not immune to the crisis embroiling the credit markets and the forces behind it, which are having a significant negative impact on high yield bonds and loans.”
The buy-out firm Apollo Management illustrates the broken deals of last year. Realogy, which owns the real estate brokerages of Coldwell Banker, Century 21, and the Corcoran Group was acquired for $8.6 billion, with Apollo putting down $2 billion in cash and borrowing the balance. Corporate bonds used to finance the deal now trades at 61 cents in the dollar, suggesting an 83 per cent chance that Realogy will default, as the American economy further deteriorates. Apollo’s equity currently has no value at all.
The distress in the leveraged loan market is most evident with Harrah’s Entertainment. Having bought America’s largest casino group for $17.1 billion, Apollo Management and Texas Group are having trouble selling $14 billion in loans and bonds to third parties. The comment from the Financial Times is that “with the bulk of the debt remaining on their books, the banks could be left with a sizable loss.”
