Falling prices are forcing total-rate-of-return market-value CLOs to liquidate their underlying assets. These unwinding CLOs could present opportunities for investors, but could also drive prices down even further. And sources say the loan market has already hit historical lows.
UBS and Wachovia are reportedly liquidating $264.9 million and $446 million in CLO paper, respectively, and at steep discounts. Citi could also liquidate roughly $1.5 billion in CLOs. Fitch Ratings recently downgraded roughly two dozen CLOs structured by Citi and said in a report that three of the bank's CLOs are liquidating. However, a Citi spokesperson denied that the funds are liquidating and said the bank is in discussions to restructure all of these deals in conjunction with additional cash injections from existing investors. Some of the bank's market-value TRR CLOs hit their termination triggers, the spokesperson said, but added that it is unlikely these CLOs will liquidate, assuming the restructuring is successful. Bank of America, Goldman Sachs and Morgan Stanley could also be forced to liquidate TRR CLO assets, sources said.
"This happens anytime you have a bubble," said a loan trader at a bank. "There needs to be a purge. That's when all the leverage gets taken out of the system."
Market-value TRR CLOs often have total return swap/liquidation triggers written into them that are breached when prices dip too low. Breached triggers recently drove Fitch to downgrade 90 TRR CLO tranches. Market-value CLOs represent 10% of the approximately $350 billion of outstanding CLOs, according to CreditSights. The size of the total return swap market is unclear because most contracts are private.
"This has never happened on this scale before," a Fitch analyst said.
The key difference between the selling that dominated 2007 and what is happening now is price, CreditSights analysts noted in a report published last week. The forced selling that took place in 2007 was more linked to risk reduction. The analysts added that the market is currently experiencing a degree of technical pressure that will ultimately mark the bottom.
Loan prices are unlikely to rebound from current levels until the pressure from the potential market-value CLO unwind, among many factors, is assessed and the restructuring efforts are successful, according to a Lehman Brothers report. Bank of America analysts also said in a report that loan prices may continue to fall.
For leveraged loans, 80 has become the new 90. Prices on Markit's LCDX fell to an all-time low of 90.2 last Monday, but had rebounded slightly to 90.58 by midday Thursday.
Investors fear that these liquidations could lead to the entire TRS market unwinding, according to a Wachovia report. But whether the triggers will cause a vicious cycle of liquidations and further price declines depends on investors' ability to put up new capital, Lehman analysts noted. As the structures can be re-equitized without liquidation, new capital can stem the risk of spiraling price declines, they added.
Market-value CLOs generally have unrated tranches at the top of the capital structure. Usually, the bank that structures the deal takes the unrated risk. The bottom portion of the capital structure, meanwhile, is rated and sold to investors, who receive a fixed coupon with upside if the assets in the portfolio perform well. Investors were attracted to this structure because they could buy rated tranches with some equity upside.
Total return swaps operate by having the swap counterparty, typically the underwriter, retain the loans on their balance sheets. Generally, the agreement is structured in a fashion similar to that of a revolver. The swap provider agrees to provide a limited amount of capital but it is not necessarily fully utilized by the swap receiver. Loans were the most common asset to take advantage of total return swaps and constitute roughly 90% of their reference assets, according to the Bank of America report. To a lesser extent, corporate MBS, CDOs and ABS also took advantage of total return swaps.
To avoid liquidation, market-value TRR CLOs can be restructured into cash-flow CLOs. This could offer the advantage of preserving options for equity holders (who might otherwise be forced to write them off) by insulating them from market-price volatility until loan prices stabilize, hopefully at higher levels, the Lehman report said. However, this also creates new cash-flow CLO triple-A tranches in a market that is struggling to absorb debt, Lehman analysts added.
A market-value CLO differs from cash-flow CLOs in that the market price of the underlying collateral, not just the cash-flow generation from the underlying collateral, supports the deal structure. The goal of a market-value structure is to generate a total rate of return and risk that is tied to market prices, not just to the ability of the underlying assets to pay interest and principal.
"I heard that Citi is looking to turn some market-value CLOs into cash-flow vehicles," the trader said. "Hedge funds should be able to take the bait."
However, Bank of America analysts said the vast majority of hedge funds access the loan market through total return swaps. This implies that there is about $100 billion worth of total return swaps out of the $550 billion leveraged loans outstanding, the analysts noted. Obviously, a potential unwind or restructuring of roughly 20% of the loan market would have highly negative implications throughout the credit markets, the Bank of America analysts added.
Despite the dire outlook, there is optimism in the loan market since some see new opportunities following the meltdown. "Over the last couple of days, we have seen a number of nontraditional investors inquiring about opportunities in the loan space. I've talked to a number of private equity sponsors over the last couple of days, prop funds at some of the banks, equity guys," a bank strategist said. "The concept is: We know that the fundamentals are going to deteriorate, but my gosh, valuations have just collapsed over the past couple of weeks. So maybe you've moved a little bit too far too fast, and there might be an opportunity."
Adding to the good cheer, Wachovia analysts said the liquidation process so far has been orderly, with multiple bidders and few fire sales. The loan market, Wachovia said, still has enough experienced investors who view this period as a significant buying opportunity. While the increased volatility will keep the CLO market closed, it could help its long-term prospects once prices stabilize at newly discounted levels.
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