This March, the U.S. collateralized loan market moved the clocks forward an hour…and seemingly the calendar back more than a decade.
Asset managers who had routinely filled up on senior corporate loans for new-issue portfolios suddenly had leveraged loan pipelines go dry. Those looking to trade their existing loans were finding takers only at deeply discounted prices. Investors were stepping back, too, as managers discovered the spreads required to attract institutional buyers was untenable. Sources say market conditions deteriorated so broadly that PGIM Fixed Income, Nassau Corporate Credit and Trinitas Capital Management each reportedly pulled new CLO offerings in mid-March.
In effect, it was 2008 all over again – perhaps worse, as the reality of the worldwide coronavirus outbreak began to take shape.
“Originally, CLO investors seemed to brush off the worries of the pandemic,” says Olga Chernova, the chief investment officer of Sancus Capital Management, a CLO structuring specialist. “The inconvenient truth that global pandemic could lead to a global recession started to settle in around the 15th.
“From there, we have reached the levels of the 2008-2009 in a span of 1.5 weeks,” according to Chernova, in an email.
The shock and paralysis last month was pervasive across the asset-backed and structured credit markets, including mortgage-backed securities, as the COVID-19 contagion spread amidst a resulting global economic shutdown.
Analysts say government maneuvers such as the Fed’s new term asset lending facility program and the newly enacted $2 trillion Congressional stimulus package backstopping small businesses and workers have brought some calm to the early spring storms to the ABS market. Some large asset managers with deep pockets, such as Apollo Global Management and Oaktree Capital Management, have already ramped up plans to take advantage of cheap distressed-debt buying opportunities.
But even the near-term prognosis for the market remains in deep flux entering the second quarter of a year that bears the hallmarks of a sharp slide.
“Pricing is cheap, risk is heavy, selling pressure disarming,” wrote another asset manager, in an email. “Nobody wants to be a hero right now and nobody is calling this the bottom.”
What follows is a sector by sector look at how conditions in the ABS market are evolving and what market observers expect might be coming next.
MBS headwinds
Private-label residential mortgage-backed securities were off to a brisk start this year, with market observers projecting a large market-volume increase from nonbank lenders this year. Even after a tumultuous March, non-agency RMBS volume of $30 billion through the end of March was still pacing ahead of 2019’s levels ($26.8 billion). The market even saw two re-performing/non-performing mortgage offerings launched from real estate investment trust Chimera Investment Corp. and FirstKey Mortgage.
But now lenders, servicers and real estate investment trusts are sweating out how the introduction of mandatory forbearance programs for distressed borrowers will affect their cash flows into asset-backed portfolios.
“In some pools,” warns Patrick Wacker, a New York-based portfolio manager for Insight Investment, “modifications or payment holidays may prevent a deal structure from breaching a delinquency or loss trigger. Senior investors will be penalized in this case.”
The Federal Reserve established a credit facility for servicers that comply with forbearance programs established by Congress and the Federal Home Finance Agency (which oversees Freddie Mac and Fannie Mae), but non-bank servicers could still see strains on liquidity from
"I don't think the government wants the servicers, that are mostly non banks, to have serious financial issues," said Richard Simonds, a partner in the finance group practice of Alston & Bird. "So one of the most important things about programs like TALF Is that they need to be made available to servicers to fund the service, the advances they're going to need to be making on these loans if they're delinquent.
"If the government tells homeonwers that they could be delinquent, you know, that's going to make a lot more of them delinquent," he added.
“Depending on the structure and covenants, bond insurers are likely to become much more important in the securitized markets,” added Brian Sterz, a portfolio manager for Los Angeles-based Miracle Mile Advisors.
For commercial mortgages, the pain for lenders is already visible on the horizon. Data research firm Trepp projects commercial real estate defaults will rise to 8% (from the current 0.4%) based on a modeling of 12,500 loans totaling $77.5 billion. Retail sector defaults alone could rise to 16%, which is higher than other sectors like office and industrial properties.
According to Fitch, master servicers “have already become to receive debt relief requests from borrowers” in conduit fusion transactions, most of them hotel property owners whose revenues have collapsed from the demise of travel from the growing shelter-in-place movement across the country. (The agency estimated on April 2 that more than 2,600 borrowers have sought rent relief from owners of properties backing commercial-mortgage securities).
“CMBS single-asset securities backed by mortgages on hotels or malls would be among the asset classes most at risk, absent significant intervention,” said Edward Weil, the director of law firm Dykema’s financial industry practice.
Shuttered movie theaters, a top-five tenant in 192 North American properties included in CMBS transactions, are the source of more than $3 billion in “elevated” risk in those deals, according to ratings agency DBRS Morningstar.
Deutsche Bank analysts think the Fed could – and should – add CMBS to the asset classes eligible for TALF 2.0, based on how well $10 billion in loan disbursements under the original TALF program launched after the financial crisis had boosted CMBS activity by $71 billion of new-issue and secondary-market bonds.
One of the few safe assets cited by analysts in CMBS are office properties, many of which are tied to long-term leases that require tenants to continue paying rent. But even those deals still face potential long-term woes in the aftermath of a post-coronavirus recovery. “As main street businesses consider shuttering, companies recognize that they may be able to function just as smoothly with remote employees and less office space,” noted Miracle Mile’s Sterz.
Consumer apocalypse?
With federal backing of expanded state unemployment insurance programs, investors are hopeful that consumer confidence can somehow navigate a short-term coronavirus disruption. At least, that’s what issuers and economists believe as the sector’s best hope to avoid a recessionary catastrophe. “We’ve got to convince people that we’re not going to have the apocalypse when it comes to consumer credit,” said Chris Whalen, chairman of Whalen Global Advisors.
According to Insight Investment’s Wacker, online marketplace loan securitizations may pose the largest immediate risk for ABS investors in the consumer space. “An unsecured consumer loan clearly ranks last,” in payment priority for a distressed consumer, he stated. And while these deals are well-buffered against losses with up to 40% initial credit enhancement on notes, the “relatively new-issue senior unsecured consumer ABS is at the greatest risk of loss as the structures have not had time to de-lever.”
But the $15.2 billion size of that fledgling market’s 2019 new-deal volume pales in comparison to the $110.6 billion in securitizations of prime and subprime auto loans, leases and dealer inventory financing last year. And auto ABS is beset by more than the woes of consumer stress; the industry also has its fortunes tied to the fast-declining prospects (and credit ratings) of global auto manufacturers. In late March, auto industry analyst firm ALG projected as much as a 34% decline in year-over-year new-car sales in the U.S., a turn that would drastically cut revenues for captive-finance companies that source most new-auto securitizations each year.
U.S. finance arms for Nissan, Toyota and Ford were downgraded in March by various credit ratings agencies, while those for General Motors and Hyundai were put under review. (Moody’s Investors Service also shifted the outlook or American Honda Finance – one of the market’s most stable performers for nearly 30 years – to negative).
But existing ABS deals would be most impacted by rising consumer defaults and delinquencies, particularly in subprime where late pays are more pronounced and auto repossession recovery values are lower.
“There’s a tail effect here in existing deals. It may be a few months before we start to see the damage done to borrowers,” said Joseph Cioffi, a partner with law firm Davis & Gilbert who pens a regular blog on consumer finance products including auto loans.
Fitch placed the 2020 asset performance expectations for auto loan and lease securitizations to negative following the then-record 3.3 million jobless claims for the week for March 21. The agency noted lenders and services have already implemented consumer assistance programs, including temporary forbearance that will tack on payments to the end of loan contracts.
But even with an end to the coronavirus epidemic, don’t expect car buyers to return in droves to the market, warns Moody’s Analytics. “The second punch to demand from a COVID-19 recession will come as people naturally react to lost jobs and wages,” the firm stated in a March 19 report. “Fiscal intervention may stave off the brunt of the downturn but will be unable to stop the downward spiral that has already begun.”
The expected impact on small businesses (
Small business are “the largest employer in the U.S.,” said Boris Revsin, managing director for Republic Labs, which invests in late-stage venture and private equity deals in the technology, consumer and service industries. “This group of entrepreneurs is highly vulnerable, and many businesses that should stay in business are at risk of folding.”
Aircraft ABS: stalling
The controversial bailouts to the airline industry by Congress were drastically needed, argued the International Air Transport Association, which projects a nearly 37% year-over-year decline in air traffic. The industry faces “its gravest crisis” without government aid, the IATA stated on March 24; otherwise “there will not be an industry left standing.”
Despite assistance to U.S. and global airlines from domestic governments, the pressure on aircraft leasing securitizations is just starting to mount. According to a Deutsche Bank analysis last month, leasing firms are being barraged with rent-relief requests from airlines – requests which lessors may take up due a lack of better options. Leasing firms may choose to grant the requested deferments (payments which are otherwise due under so-called “hell or high-water” agreements), since no other operators are likely available to take on any repossessed planes in this environment, according to Deutsche.
The deferments compound a problem the industry also faces with expiring plane-lease renewals this year. Deutsche tracked nine aircraft-lease ABS deals with at least 20% of assets on expiring leases this year - on aircraft likely to be returned by struggling airlines cutting back on routes.
Other esoteric and transportation ABS transactions face similarly deep stresses. A collapse in trade, alongside the already-delayed China-U.S. trade agreement will add to what was a 1.75%-3% decline in railcar freight traffic this year, according to Moody’s, putting on a strain on railcar lease and related shipping container fleet ABS deals.
Rental car ABS transactions financing fleets will suffer the revenue loss in the fall-off in travel, and are also excluded from the Fed’s TALF program, noted Moody’s. Most deals have excessive collateral value, however, to withstand a temporary cash-flow interruption and falling recovery rates of vehicle sell-offs. Moody’s explained the senior, investment-grade notes in major rental-car securitizations are built to withstand 45%-60% drops in value, for instance
CLOs
Senior notes in the $670 billion collateralized loan obligation market are also built to withstand market disruptions and corporate borrower defaults and delinquencies. The deep levels of enhancement as well as maintenance failure tests that require diversions of a manager’s payment-and-interest waterfall to senior noteholders if triggered.
But the 2020 collateralized loan obligation market brings about a new level of risk not seen in the previous financial crisis the market endured in 2008.
According to London-based investment analyst firm Fideres Partners, U.S. and European CLO noteholders of subordinate-note tranches face “significant” losses of as much as $100 billion over the next two years from corporate-loan defaults stemming from the COVID-19 impact. The losses will be felt “in particular, to investors in equity, B and BB [rated] tranches,” Fideres noted in a March 24 report.
Those losses would exacerbate the expected stresses on CLOs from a torrent of secured-debt downgrades already underway with corporate borrowers (CLOs hold approximately 71% of the estimated $1.3 trillion leverage-loan market). Downgrades have impacted about 10% of the loan assets under management in reinvesting BSL CLOs, according to S&P. Since February, the agency has downgraded 94 high-yield borrowers, which include leveraged loan issuers, due to coronavirus impact.
A continued rise in downgrades is likely to raise triple-C rated note exposure in deals, triggering test failures that would ultimately stifle cash flow into the ownership stakes (or equity) of CLOs.
Most deals limited triple-C rated note exposure to 7.5%. Current exposure averages only 4.4%, but Deutsche Bank believes it could rise to an average of 10.2% based on historical Moody’s data on the 2009 speculative-grade downgrade and defaults patterns. Excessive holdings of CCC-rated assets would trigger failures in minimum average ratings factor tests in deals – breaching minimum overcollateralization requirements and likely stifling cash flow into the ownership stakes (or equity) of CLOs.
In mid-March, managers of reinvesting collateralized loan obligations were spinning wheels, unable to trade out of deteriorating assets without taking a bath on distressed prices. While the cost of buying loans dropped to more than 80 cents on the dollar (with spreads widening to their highest levels since the crisis), managers were still unable to pull triggers on deals due largely to the fact they gained the assets before March’s steep decline.
“Because loan prices have dropped so quickly, it seems that a lot of warehouses may be underwater,” said Larry Berkovich, a partner in the structured finance practice of Allen & Overy. “Fortunately, most bank lenders of the CLO warehouse lines are taking a “wait and see” approach with the CLO market, allowing managers to maintain their lines without necessarily approving any more asset purchases, as most warehouse agreements do not force mark-to-market triggers on underlying loan asset prices, he said.
Falling loan prices do not affect existing CLOs, since assets in portfolios are not priced to market value except when being sold. Many already see similarities to the opportunities that came from the 2007 collapse in leveraged loans to an average of nearly 60 cents on the dollar – the potential for a buying spree.
“Many CLO collateral managers are considering the current volatility to present opportunity,” said Tom Majewski, managing partner for Greenwich, Conn.-based Eagle Point Credit, which invests primarily in third-part equity in CLOs. “We can see scenarios where the 2019 vintage of CLOs will end up with performance similar to the 2007 vintage.”
CLO managers “have an unprecedented par-building opportunity that could significantly offset (and potentially even exceed) downgrades impact on OC tests,” said Sancus Capital’s Chernova.
“We are hoping that on the CLO side, we are hoping that on CLO side this crises would show the importance for CLO managers to have flexibility to trade,” Chernova added. “Often debt investors are eager to put trading restrictions on the portfolios, however, in the pandemic scenario when everything sells off, ability of managers to maneuver, make swaps and create par would benefit all.”
