CDOs Roundtable 2007: Part 2
IFR: So do you think there is a possibility that some arrangers might not be in the market given their warehouse lines are full and underwater?
Combe: The problem with leveraged loan arrangers, and they are all slightly different, is to do with the hung syndications. As I’m sure all of you know in Europe we think there is about €70bn of hung syndications right now. The problem in the US is much worse.
That short-term problem has a long-term effect. In the short-term, those people will not underwrite new deals because they are sitting on very concentrated, in some cases very unpleasant, risk.
If we are all right about defaults staying low, we will be okay for all of the right reasons but warehouse providers have got some real short-term pain to take. Many of them have already taken it.
Even when all of that has flown through the system and is eventually sorted out, which may take 12 or 18 months, there is a much longer-term problem which is that there will be a transition of power within investment banks from syndicate desks to heads of credit; a reversal of power, if you like, back to the heads of credit.
In recent years, syndication desks have become all powerful, and the credit guys have been sidelined. That will change. Investment banks, being large organisations, operate like super-tankers. Once change is made, the heads of credit will still be in charge in four years’ time; not the heads of syndicate, even when everything is completely back to normal in the syndicate market.
So I believe we are going to see a structural lower supply of big capped leveraged loans over the next five years compared to the last five years.
We really do believe that we have seen the peak of the big cap LBO market. It is going to be very hard for banks to underwrite big deals for quite a long time.
IFR: How will this impact CLO issuance, Vincent?
Dahinden: We will see a shrinking of the participants.
IFR: We have had some tremendous league table growth among some players in the last 18 month, how will this change?
Dahinden: Last year there were about 70 or 75 CLOs priced in Europe, a threefold increase from 26 the year before. That growth was absolutely gigantic and as a result we reached a point where the market basically didn’t have the capacity to deal with that number of transactions.
We started to see second-tier managers, even in primary, trading at discounts – even on the equity or sometimes on the debt. So it was a sign from investors saying: “look, I am going to take that but it is going to have to be at a price”. So you had an early sign that of a dislocation between supply and demand.
Out of the 70/75 CLOs last year half of them came from new managers, half of which actually came from the US. If you look at the larger arranging banks, there was a capacity issue with them as well. Some had a strategy not to do every deal that came their way. But those deals had to get done by other arranging banks.
So we have seen a flurry of newcomers on the managing side and on the arranging side as well. And even just interviewing and hiring structurers, the quality of the people available was way below what was required for that many deals to be done properly.
If you look at the ability of the trustees to deal with so many deals, I think that was also very stretched. If you look at the capacity of rating agencies to deal with so many transactions, clearly they were overstretched.
At times they could not return phone calls within a [reasonable] period of time. Most probably they would have liked to return the calls. The lawyers were telling us that they could not deal with the influx of transactions. You probably had five leading law firms that most of the key managers were working with.
So if those people were full, the excess was given to second, third-tier managers, to second, third-tier arranging banks, to second, third-tier law firms and so on and so forth.
You will see that last year a lot of arranging banks brought CLOs for the first time.
Burgel: The CLO market really only followed the explosive growth of the leveraged loan market, which actually tripled in overall size over a two-year period and, because more and more was done as institutional tranches, it has probably quadrupled for institutional investors.
Dahinden: All I am saying is the market grew faster than the actual capacity to deal with that growth. The infrastructure was very stretched.
Tromp: Although it is not totally clear which one came first. Was there an environment in the corporate sector that was conducive to more leveraged buyouts or were more leveraged loan being structured?
Because there was so much demand from investors, leveraged loans became efficient and attractive to borrowers. But clearly we are going to see an adjustment in the volume there that is going to be driven by the fact that the demand for CLO paper is no longer there, or no longer there at the terms that were prevailing until last month.
IFR: Ian, Vincent mentioned the fact that the agencies were overstretched. Is this prospective consolidation a welcome development?
Perrin: We had been extremely busy since the last two quarters of in 2006. Just as the market was growing, arrangers were expecting transactions to be done at a quicker rate. So there has been a lot of pressure on us.
The positive of what is going on at the moment is we are really going to see this shift of power back to on our side.
You will see how over the last couple of years points in documentation, which were not necessarily rating agency driven but more investor driven, have disappeared. We are expecting a lot of these points to come back.
IFR: Can you give an example of that?
Perrin: We made sure that features like the haircut to deep discount assets was present in the documentation. We made sure that we modeled by parent risk.
I think we had to fight to have some points included in the documentation over the last two years. When the CLO market is back we do not think we will really have this issue again . . . of having to fight to say we want this or that in the transaction.
IFR: So it is a welcome development for investors?
Perrin: From our perspective definitely it is a welcome development. It is really back to credit analysis which, from a rating point of view, is what we are supposed to be doing.
Tromp: But I think there has been an evolution towards structures that had bells and whistles, they were there to enhance the return of the portfolio and make the economics of the transaction more attractive at the expense of investors.
And certainly, from our point of view, talking about the senior tranches, there was an increasing fashion to pollute or depreciate the value of the leveraged loan collateral. You ended up having CLOs that were not senior secured loans deals even though that is what we like to see. We like to see portfolios that are made up of, for the most part, senior secured loans.
You had buckets that were getting larger and larger for bonds, for synthetic exposures, for mezzanine, for structured paper and so on. We need to decide whether it is a CLO or if it is some kind of CDO with all kinds of arbitrage instruments in there.
The leveraged loan is a good product and certainly with the better covenants that will come through it could become even better, but let’s make CLOs true securitisations or refinancings of these portfolios of leveraged loans, as opposed to arbitrage entities that have all these additional features.
So to the extent we can shift back to structures that minimise these buckets we think that the market has a great future. And certainly from our point of view, we look forward to participating even more actively than we have.
IFR: So you have greater appetite for Triple A provided it is not polluted with other higher yielding collateral?
Tromp: Absolutely. We have always done deals but we have been challenged by the fact that we had to find deals that we could do. We fully understood that people went away from us because there were buyers that could live with these features in a CLO, that in our view were not palatable.
So to the extent that that demand disappears, we hope bankers will come back to deals that we can do more of. We are open for business. We actually think that what has been happening is great news. It is the best news we’ve heard in years.
IFR: But speaking on behalf of your peer group, there has been a significant widening in monoline CDS and their share prices have fallen quite substantially. Don’t you think that this is likely to impact monoline demand?
Tromp: Yes, it has an impact in terms of investors taking exposure to monolines, and to the extent they want to hedge some of that on the delta hedging basis, or in full. Clearly it is part of the equation that makes the liability side of CLOs more expensive.
Is it going to stay at that high level right now for a long time? Maybe not. We think that it should settle at some lower level for the greater good of the market.
I think the CDS spread on monolines is affected by the fact there is a lot of people that have exposure and they need to hedge that. So it could mean technically they have to buy protection and it’s really only been one way because the only thing monolines do is sell protection, which means a market that by in large is one-way. It’s a market that is prone to getting wider as soon as there are credit issues.
The FSA has been fortunate in being the one to trade the tightest by a multiple factor for a number of reasons. The perceived exposure to US sub-prime via ABS CDOs could be to blame. But I think that monolines generally will continue to participate in the CLO market and they will be one group of investors among others. Hopefully in a market that can offer terms that more readily meet our requirements than was the case in the last two or three years.
Dahinden: Apart from the FSA, there is a complete dislocation as to what the wrap package would be. I think for other monolines it will be a challenge, people won’t take that risk when they can get paid twice as much by taking the same risk directly in CDS.
Tromp: The evolution towards a negative basis trade-driven market is a recent one. If you go back to 2000 or the 1990s when we were doing CDOs or even CBOs, we were providing financial guarantees. Interestingly enough, we are seeing new opportunities that we have not seen in years to provide financial guarantee wraps on the senior notes of CLOs.
Dahinden: Which you can do, of course, for CLOs but you can’t for single tranche business.
Tromp: Exactly, which we can do and which we can price a lot tighter than CDS because it is not a mark to market instrument. At the moment, there is so much volatility that the fact that it is not mark to market has become that much more attractive.
I think it still has to settle in terms of where it makes sense for investors to own a wrapped asset. But I am convinced that there will be demand for financial guarantees in addition to probably continuing demand for CDS hedges, but at a different price.
IFR: So from an investor standpoint, what is your view on wrapped paper?
Packman: I think you have to take a slight step back and just point out that even right now the Triple A market and CLOs generally appear to be pretty much broken because of the situation that we have with the conduits and the SIVs and the funding and the cost of liquidity and so on.
I don’t tend to focus at Triple A level anyway, but it is a very difficult question to answer until there is some form of normalisation.
Hence, the thing to focus on is what will drive the normalisation process? Probably – and Peter hit it bang on the head earlier – the answer is quite simply time and the proving of credit fundamentals. As time passes and these transactions continue to perform, that will compare to the sub-prime-backed product which looks set to continue deteriorating.
The market will differentiate again and then obviously the monolines will prove their model. The ratings will be proven appropriate to the level of risk that is being taken and things will return to some degree of normality.
But like you say, right now, why bother with the additional complexity and hassle of buying a wrapped tranche if you can use protection on the monoline?
Marshall: We have not historically been big buyers of wrapped paper because, as a substantial institution and employer of credit resources, we have always taken the view that we would rather do our own underwriting on the underlying asset pools and find extra value, rather than paying for someone else to take that risk.
You mention financial guarantees and I have the impression that we have seen evidence of some financial guarantee business being done, amongst other things, in sub-prime. I had the impression that to break the log jam you could sell bonds that were not only Triple A structurally, but had a guarantee as well.
I don’t know if this is going to happen in CLOs, whereby you get highly structured pieces, maybe Triple A in their own right, with a wrap on top, in the interests of trying to find buyers somewhere.
To take the view that CLO demand for Triple As is going to come back strongly requires you to take a view on how the bigger flows of Triple A RMBS and CMBS goes. There are big flows of money that still to take place.
CLOs are not that big a number in the scale of the amount of mortgage-backed paper that has to move with it. All of which is a roundabout way of saying that I think there might be a place for wraps through reigniting interest by saying: look, here is gold-standard paper with an additional imprint on it from someone else.
Burgel: Seven years ago we did a transaction together with FSA and that was basically with an old financial guarantee. That was just the way that you would do these things at the time – in 2001 – in the face of the more uncertain investor demand when the CLO market set out to prove what it could do.
But we have always focused on cash buyers because subsequently, even for that transaction, I think there were eight or nine cash buyers that also benefited from the guarantee by FSA. We have always focused on the cash buyer market. The signals that we are getting at the moment from some of them is that they continue to be interested.
I would still suggest that CLOs overall will become more important in the ABS mix for many investors, because the underlying is just more stable and is also actually reacting very quickly to the benefit in terms of underwriting standards on the underlying.
Packman: I guess there is a degree of investor education that needs to go on there, because if you rewind two or three years, just broad balance-sheet lending, corporate SME CLOs were treated by investors in the same way as leveraged loan deals. It took some very large deals that brought them into the mainstream.
The performance of leveraged loan CLOs should mean that over a period of time the broader market accepts it as more of a vanilla ABS product rather than viewing it as it did in the past as a CDO kind of product.
But that is really a process that has been halted in this liquidity crisis. Certainly from my experience there appeared to be a kind of burgeoning group of investors that were more appreciative of the leveraged loan CLO product and its stability and its fundamentals and more investors that were starting to incorporate it.
Unfortunately a lot of those guys now will have been burnt on the mark to market basis and the question is, how do you then bring them back in over the longer term because, quite simply, if Triple A prime residential mortgages are available in the 40bp to 60bp area your average fund manager would buy that first because that is the familiar home ground.
Dahinden: Yes, and I think investors will recognise that there is a difference between a leverage loan CLO and a CDO of asset-backed. Right now I think it is fair to say there is a contagion effect where everything seems to be affected in the same way because liquidity has been pulled out.
No-one is buying, so therefore everything drops in the same fashion. But one has to not forget that if you invest in a CLO, you have to know you are buying into leveraged loans. It is astounding to hear the number of managers or investors who never, ever drill down into the loan types or the actual collateral of asset-backed securities – they just have no idea.
It reminds me of the CBO market in the 90s where high-yield bonds were basically the collateral of choice for CDOs. People were buying the transaction on the basis of, “Oh, this one has a 24.5 IRR, this one is 23 – I am buying that one”, and that was really the only criteria. Those days are not that far away.
Kilcullen: I think you have to look at what has driven people out of this market in the current environment and that is losses and issues on other asset classes.
Marshall: And these asset classes. Everything has been marked down and CLOs have been marked down further than mortgage backed, because that is what people do.
Kilcullen: Yes, on a marked to market basis, but there is a spiraling effect and a vicious circle that has been created to a large extent. What will bring people back to this market is the fundamentals. They will look at the fundamentals of the leveraged loan asset class and the robustness of the CLO structure and they will be tempted back.
Marshall: But if you go back to the fundamentals of the asset class then you are looking at higher leveraged multiples – by a margin – than you had one, two, three, four or five years ago, and that is the issue for me.
It was mentioned a while back that the correction in CLOs started before much of the current chaos began. Back as far as February or March, CLO spreads started to move wider in certain parts of the capital structure because of the indigestion issue.
Then later in that process, and before the ABS meltdown, I was getting the sense that there were credit worries, just the beginnings of some credit worries. People were saying the multiples are high, if I, as a buyer, have choices between CLOs or European mortgage-backed securities, maybe I will consider rebalancing on the basis that I am happier with the fundamentals in Dutch mortgages or UK prime mortgages than I am with CLOs.
Combe: I agree leverage had got too high in European LBOs. I think pricing had got too tight and structures too weak. You know, toggles, cov-lite, all of those unpleasant things, security packages not properly done; all of those things that had worked in leveraged loans for many years were beginning to get quite shot. So I think you are absolutely right.
What I meant at the beginning when I talked about an orderly repricing of all of that risk is that I think that CLO investors and the whole institutional market have been quite fortunate and quite clever in a way. It has almost used the excuse of sub-prime and all of these other extraneous events to re-look at this whole package of risks and to draw a line under it and say, “yes, it is too high”.
Packman: I think it is giving the market somewhat too much credence for being cleverer than it actually is.
Tromp: There was a compounding of various issues that came together at the same time: the supply, the reduction in lending standards, and the fact that, had the sub-prime mortgage market not fallen over, had the leveraged buyers of that product not also been big buyers of the CLO product, you would not necessarily have seen this chain of events.
I think there is definitely a lot of contagion, in terms of a lot of the owners of US sub-prime products are also the owners of US CLOs, which meant they were shut out the market or forced to sell products from their portfolio that they could sell when they could not necessarily sell US sub-prime.
A lot of dealers on the sell side that covered the US CLO also cover the European CLO, so when they get nervous on the US side, they start to get nervous and take liquidity away on the European side. These things start to feed across and seemingly unconnected elements of the market start to connect via relatively hidden routes.
So my perspective on this is not so much that people have taken advantage of a situation, I think the simple fact is that this series of events has occurred that has put people in a situation where they have to do something with assets unrelated to where the problem is to try and save themselves, and that has then led to a repricing and a problem in other products.
Perrin: I think the sub-prime market has kind of accelerated the repricing of CLOs, but even if that had not happened I am sure that within four or five months CLO managers would have stopped buying paper, because it was not interesting for them.
Combe: But to some extent it is an academic discussion, is it not, because it is where it is? What I do think is quite interesting as circumstantial evidence, and Oliver you are probably the expert on this, but if you look at the rash of big leveraged buyouts that were done post-Easter, before the credit crash, I think a lot of institutional buyers were beginning to turn those down. People had started getting very nervous – there is no question about that.
Click here for Part three of the Roundtable.