Eight key players involved in European CDOs recently gathered to talk about the impact of this summer's liquidity crisis and how the CDO and wider securitisation markets are likely to change.
The consensus was that the demand/supply imbalance will eventually find a new equilibrium but banks will have to write down the overhang of underwater loan assets before a meaningful recovery can get underway.
Given institutions are holding tens of billions of stranded leverage loans, assessing warehouse risk, which was previously not such a priority, will now become more important.
On the liability side, some players are still in a state of denial but it is only a question of time before the real market clearing level finally dawns. However, this need not be a problem, provided the underlying assets still provide arbitrage, and the suggestion is that this will indeed be the case.
Participants also argued that even if the sub-prime crisis had not happened, a re-pricing would probably have occurred anyway. Mezzanine debt had started to leak wider in March and April and, even before that there were underlying issues with the loans themselves, with managers beginning to question where the arbitrage was.
On the positive side, though corporate defaults are expected to rise, the underlying economic backdrop is fundamentally solid.
Refinancing is likely to decline and it is probable that weaker corporate entities will hit problems. But these are arguably firms that should have gone to the wall long ago and were perhaps only being kept artificially alive by the extraordinarily liquid market that had preceded this summer's turmoil. Apart from taking out the weaker entities, a lower refinancing rate will mean managers have less difficulty staying fully invested.
Investors are expected to become more discerning and prospective manager tiering that will continue but to a much greater extent. Weaker, less well resourced managers who relied on short-term funding could be among the most vulnerable.
Along with the shrinking number of participants, it's likely there will be a lower supply of big cap leverage loans over the next five years, compared to the last five years.
But this is no bad thing since it's clear the market had become overstretched. The CDO sector has outgrown its infrastructure and did not have the capacity to deal with the enormous volumes that were being witnessed in the run up to the summer.
To entice the more discriminating investor back to the table, the quality of underlying loan collateral will have to improve – with deals backed by cov-lites, synthetic buckets, PIKS, high-yield, mezzanine and second lien likely to diminish or disappear altogether. Dividend recaps and late structural amendments will become less frequent and leverage will probably fall.
And from an organisational perspective, bankers are likely to see a subtle though definitive change in power within their own organisations. Syndicate desk heads will no longer call the shots and will become increasingly answerable to the heads of credit.
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