Despite what seems like an almost nonexistent CDO market, bank balance sheet CLOs are still garnering investor interest, according to sources.
While many of these deals are not publicly marketed, the high premiums banks have paid to get them done, combined with the "lower risk" structure of the trades, are keeping investors interested in the sector.
Balance sheet CLO issuance has been touted by some as the driver behind the expansion of the CDO market. These deals are traditionally done to address regulatory capital management requirements, where a bank needs to hedge a portion of the loans held on its books. These transactions boost return on equity requirements by reducing a bank's loan exposure.
With recession fears and an unstable structured finance market, it seemed that after last summer investors started shying away from structured credit vehicles of any kind. But this is not the case, according to Allan Yarish, chairman of the International Association of Credit Portfolio Managers and a managing director at Societe Generale.
Yarish said that the old-fashioned Basel I trades used in balance sheet CLOs, which some banks were still doing in 2H07, transfer a low level of risk, which is the major reason why there are still investors in the space. The issuing bank normally retains the equity in these trades, and through that and other mechanisms, "investors can get comfortable that they are not being exposed to massive migration risk," Yarish said.
Banks have also paid a high cost to get these done, Yarish added. "It can make sense for a bank in the context of the overall profitability of borrower relationships," he said. "And, viewed against the costs of alternative sources of managing the balance sheet, it can still be an attractive price, even though it's now at least two to three times more expensive than before the summer."
Furthermore, while banks may take a hit on a portion of what they are trying to sell, they may be doing so to get people comfortable with looking at the assets, said Brian Yelvington, senior analyst at CreditSights. "If you simply just waited for a sunnier day, you can't get those assets off the books because nobody is looking at them," Yelvington said. "You have to grease the wheels, if you will."
Higher Up the Spectrum
Another thing calming skittish investors is the fact that investment-grade corporates, which have primarily backed the more recent balance sheet CLOs, are not as susceptible to the credit stress that is shaking up the high yield sector. Indeed, since the end of November 2007, spreads on speculative-grade bonds have widened 138 basis points, while secondary spreads of B-rated loans have widened 125 basis points, according to Standard & Poor's.
But credit fundamentals are being trumped by market technicals right now, Yelvington said. "Prices right now reflect calamity to come, and not current fundamentals."
While it would be completely naive to think that defaults will not rise at all, SocGen's Yarish said that he did not expect the market to see high levels of investment-grade default stress that could upset these deals. "In a balance sheet CDO done against investment-grade underlings, where you're issuing double-A or triple-A or super-senior pieces, there is a lot of subordination protecting the investor," he said.
Wait-and-See Mode
But not all market participants are convinced the future is robust for bank balance sheet CLOs. "Issuance is all based on speculation right now," said a CDO market participant. While it makes sense for the banks to do these types of transactions because they are overloaded with bank loans and need to make space on their balance sheets, given the current economic environment, it remains to be seen what type of market there is for these deals, he said.
At the same time, Fitch Ratings announced that it will be making changes to its corporate CDO rating methodology, keeping a close eye on the $75 billion in rated investment-grade synthetic CLOs.
"We are appropriately flagging the broader risks we are seeing with this product," said John Olert, managing director and head of Fitch's structured credit group, who noted that risks in these structures include adverse selection, concentration risk and the relatively thin credit enhancement cushion. The structure and seasoning of the transaction will also be taken into account. "What history is quickly showing us is that not only are there lessons to be learned from the structured finance CDOs, but there was also unexpected migration in synthetic corporates that caused some of these transactions to underperform," he said.
Since the beginning of the year, the U.S. has seen only one CLO in the market and Europe has priced only four balance sheet deals, of which three were SME CLOs, according to JPMorgan Securities research. While the issuance in January has always been slow, there was previously a buildup in the forward pipeline, analysts said. Currently, however, there have been only two CLOs added to the U.S. forward pipeline and four CLOs added to the European forward pipeline.
Other structured finance transactions that have come into the market include funds that are able to make relative value decisions, SocGen's Yarish said. "People who were formerly looking at equity tranches are now prepared to look at mezzanine tranches because the yields have improved significantly," he said. "Rather than staying in the equity space and getting a really high yield, they get a good yield and get some subordination protection."
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