CLO market participants at the Information Management Network's 14th annual ABS East conference in Hollywood, Florida last week expressed confidence in the sector's long-term performance, despite the currently depressed spreads.
With triple-A CLO spreads at 500 to 600 basis points, double-A spreads at 800 to 1,000 basis points and single-A spreads at 1,000 to 1,500 basis points, pricing has begun to factor in macroeconomic uncertainties, panelists agreed.
By the end of 2010, the speculative grade corporate default rate is expected to reach 23%, according to Standard & Poor's. Economic deterioration has put a strain on consumer businesses, which face a rising unemployment rate and increased trouble borrowing.
Defaults are expected to be highest in second liens and middle market deals, one panelist said.
In determining CLO value, another panelist said the market should take into account the expected default rate, excess spread and the potential recoveries that might be achieved from a deal.
However, gaping spreads are more of a function of liquidity over credit, several panelists agreed. Indeed, default levels remain far below their 2001- 2002 rates and overcollateralization cushions remain fine, another panelist said.
It was suggested that a potential CDO library to make prospectuses on deals readily available might help draw liquidity to the sector. "I don't think there is much to hide in terms of CLO performance, and it would benefit everyone," a panelist said.
Pressure from the lack of liquidity and broader economic uncertainties have stunted new issuance. "When you see that much trading below par, it backs up the new issuance market," another panelist said.
Managers Remain Independent
Managers' responses to industry challenges were a major focus of the CDO-related panels last week.
Depressed prices, especially in ABS CDOs, have market participants trying to work out potential default situations, and infusing cash to pump up capitalization, a panelist said.
Another panelist recommended that managers should be aggressive about amending deals to make sure they remain performing.
One specific question addressed during the conference was why the market hasn't seen the consolidation within the industry that was expected to happen over the last year. It might be because managers are trying to hold on to their jobs and companies until the last possible minute, a panelist said. He noted that managers might feel that it is more profitable to hang on to the management fees from a couple of CDOs, even if the deals have hit certain triggers, versus trying to sell ownership and find a new job.
These managers might also be hopeful that the market will turn back in their favor so they might either do a new deal or cut a deal to sell their current business.
For now, the market direction remains uncertain, especially in light of the lack of the traditional buyers that have exited the sector. These include many monolines and conduits.
Panelists predicted that potential investors coming into the sector at the triple-A level might include insurance companies and endowments that may not have had previous exposure to the industry, but that remains to be seen.
There has been, and the market will continue to see, a reduction in double-B and equity investors, a panelist said.
As banks cut down on warehousing facilities for new deals, hedge funds may be able to provide some of these facilities, but only a couple of deals per quarter. "Hedge funds will not fill the role of the banks," a panelist said.
Keeping a Close Eye
Currently, the CDO market is more focused on its present exposure than on doing new deals. Managers want to know how they can trade out of their positions without affecting the structure, a panelist said.
There has also been a lot of forced selling in the CDO market, in particular regarding ABS CDOs, as industry participants look to extract value from some of these deals.
There was discussion on several panels last week about Dallas-based buyout firm Lone Star Fund's deal in July to buy $30.6 billion of super senior ABS CDO assets from Merrill Lynch for 22 cents on the dollar or $6.7 billion.
This deal valued what was thought of as high-quality collateral at less than 25% of its original value. However, it also showed that there is a market for these assets, and that the industry can extract value from a distressed ABS portfolio.
On the other hand, trading these assets on a one-off basis might make it harder to extract value, a panelist noted.
Also, because there are fewer buyers and sellers of ABS CDOs right now, it is easier to match up quality, a panelist said.
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