CLOs and CDOs Are Hot Again. Déjà Vu?
Column: The obvious danger is that a 2008 event is not necessarily a once-in-a-lifetime event when CLO lines are pulled across the board.
“The secret to success is to do the common thing uncommonly well.” – John D. Rockefeller Jr.
Collateralized loan obligations (CLOs) have become extremely popular in the last two years and are now a global $700 billion market. That number is eerily close to the amount of subprime collateralized debt obligations (CDOs) outstanding in 2008. CLO funds sell bonds to finance the purchase of leveraged loans to a range of already highly indebted corporate borrowers. In the context of mortgage loans, the CLOs act essentially as credit lines that finance debt funds making senior mortgages. Since the CLO is diversified and is only taking the senior portion of a lenders’ portfolio, the pricing is very low (Libor plus 100-200 basis points). Barring a “2008 event”, the CLO is simply providing the debt fund with additional leverage. The debt fund, in turn, can price more aggressively on higher leveraged loans as the fund thus retains the B piece, or junior tranche, of the loan. The obvious danger is that a 2008 event is not necessarily a once in a lifetime event when CLO lines are pulled across-the-board, which cause them to request immediate redemption from the debt funds. So, if some “black swan” event causes the CLOs to not renew their credit lines with their respective lenders, the debt fund will not extend the loans, will otherwise stop lending, and thus dry up liquidity in the market. This liquidity squeeze will cause markets to seize up and prices to drop. For now, though, CLOs have added fuel (liquidity) to the debt markets by making it easier for borrowers to obtain higher leverage and lower pricing on transitional or value-add properties. This added leverage trickles down to cap rates, which compress in the short-term with the caveat that the liquidity remains. Obviously, that correlation would cause all real estate prices to decline in tandem in the event of an extraneous issue.
Who is vulnerable to CLO risk? Almost all financial institutions. Japanese banks are prominent in the AAA tranche (since Japan’s bonds currently have a negative yield) and borrow dollars and euros to finance their purchases. With the AAAs, the Japanese banks would be the most protected in the event of a downturn, even they could have difficulty in rolling over their maturing loans while retaining inventory that is being held at a loss. The unrated tranches are mostly held by hedge funds and other high-yield investors. These high yield investors would be wiped out with a 20 percent correction in the market and it would have a domino effect on the market. It is estimated that CLOs are involved in at least 50 percent of all leveraged loans. The principal reason is that in a competitive deal, those lenders that do not use CLOs cannot compete with lenders that are able to use CLOs to provide the cheap leverage that is part of the senior tranche of their quote.
Just last week, J.P. Morgan Chase, Nomura and BNP Paribas announced that they are close to closing the first managed synthetic CDO since the financial crisis. Usually, these products are short-dated with very specific collateral. The synthetics would be longer dated, allow issuers to swap credits in and out, and offer higher yields. It is the chasing of yield that is driving institutions to achieve a higher spread over treasuries or swaps. The equity investor, who would require a 10 to 12 percent yield for taking the riskiest tranche, would absorb losses on defaults up to a certain level with a negotiated ability to swap out the bad credits. And with only 0.1 percent of Class A tranches and 6 percent of Class BB tranches experiencing losses, this all makes sense in moderation. As we have learned time and again though, Wall Street will likely push the envelope so long as there is an appetite for the product. What could possibly go wrong?
Dan E. Gorczycki is a senior director in the debt, joint venture and structured finance group of Avison Young in New York.