CLOs continued to squeak out new issuance in the second quarter, making them the only corner of the U.S. CDO market to do so. The good news is that, of the new CLO deals to hit the market, several were structured from fresh loan assets - rather than from balance sheet assets, which have thus far represented most 2008 CLO issuance.
"Where spreads are right now, it does not make it conducive to issuing a CLO, at least for arbitrage purposes," said James Grady, managing director and senior portfolio manager for structured finance securities at Deutsche Insurance Asset Management. He noted that the majority of CLOs that got done in the first half of the year were typically structured to clear off dealers' books. "It was more of a situation to lighten up dealers' inventories at a cost," Grady said.
But some deals put out late in the second quarter contained more fresh capital than loans held on balance sheets, a possible sign of life for the CLO market. These deals were not warehoused for very long, partly because managers did not want to risk falling asset values, said a CLO market participant. These transactions were also primarily "club deals" or partnerships between several investors - rather than banks trying to sell off paper quickly to a broad base of investors.
As of June 26, total U.S. CDO volume for the first half of 2008 came in at $12.6 billion from 29 deals, according to data provider Dealogic, a cliff dive from the first half of 2007, when there were 306 deals comprising $186.9 billion in issuance. Of this total, $6.97 billion was issued in 1QO8 and $5.6 billion was issued in 2Q08.
All the volume in 2Q08 came from CLOs alone, according to Dealogic. CLOs have also made up the vast majority of CDO issuance for 2008 thus far. CLO issuance for 1H08 came in at $11.5 billion in 25 deals. But that still pales in comparison with last year's CLO volume of $51.3 billion in 93 deals.
Among notable CLOs closing in the second quarter was most recently, a $400 million Babson CLO 2008-II that came by way of Banc of America Securities. There was also a trifecta from The Blackstone Group, totaling $1.3 billion: a $400 million transaction called Columbus Park, which closed on April 3; Riverside Park, which totaled $500 million and closed on April 15; and, most recently, Tribeca Park, which totaled $400 million and closed on May 1.
These deals, among other transactions closing in the first half, were done with simple, clean structures and were priced at levels advantageous to investors, said market participants.
According to pricing information from JPMorgan Securities, Tribeca Park triple-A paper came in at 98 basis points over Libor; double-A paper priced at 350 basis points over Libor; single-A paper priced at 500 basis points over Libor; triple-B paper priced at 600 basis points over Libor; and double-B paper came in at 900 basis points over Libor.
A $450 million Chelsea Park CLO recently priced via GSO Debt Funds, which was acquired by Blackstone in March. Triple-A paper came in at 160 basis points over Libor, while double-A paper priced at 250 basis points over Libor and single-A paper priced at 400 basis points over Libor.
The outlook for CLO market issuance among observers is that there will not be much in the way of new deals from the sector until spreads on CLOs tighten, enough so that they become more economical to issue, or until leveraged loan prices widen out enough to get the arbitrage back in place. "If loan prices continue to fall and CLO liabilities remain stable, I think that you will see a sudden flurry of CLOs done in the market," said William May, a managing director at Moody's Investors Service.
The Time is Right
While it is tough to predict when changes could begin to take shape, the market must first see a comeback of triple-A buyers, as well as a slowdown in the delevering of some banks. With the continued influx of assets into the secondary market, supply is still greater than demand, a N.Y.-based CDO manager said.
Defaults on the performance of existing deals have paled in comparison to the ABS CDO sector, although market players are proceeding with caution as rocky economic conditions continue to weaken the corporate credit markets.
Over the past 12 months, 72% of all ratings actions within the consumer products sector were downgrades, which is roughly in line with the 71% among nonfinancials overall, according to a report last week from Standard & Poor's.
However, leveraged loan default expectations have dropped somewhat. In the middle of March, the 2008 default rate was expected to reach 7.9%. While still a six-year high, at the end of May, the predicted 2008 rate fell to 5.4%, S&P said.
Another mitigating factor is that, with the covenant-lite structure of many of the loans and the PIK toggle feature on a lot of second liens, there is nothing to trip default triggers on many of these deals, Grady said, which means it could take longer for a transaction to default. "If the economy begins to sharply recover, we may not see the dramatic defaults that the market is predicting," he said.
The Top Contenders
While manager activity was meager, Morgan Stanley managed to take the top spot as lead underwriter with $3.3 billion in five deals, claiming 25% market share, according to Thomson Financial league tables. This was a jump from seventh place in 1H07 (when it claimed only a 5.9% market share), but still, the leap came amid a dramatic slowdown in the sector as a whole, and the bank's issuance was actually far below the $12.6 billion in 64 deals it issued in the first half of last year.
The rest of the top five, in order, were Citigroup Global Markets, JPMorgan Securities, Lehman Brothers and Banc of America Securities, but they had only a smidgen of last year's volume. Together, these banks issued $7.05 billion in the first half of 2008 compared with $79.5 billion in the first half of 07. Merrill Lynch, which stood at No. 1 in 2007, has had to contend with more than $30 billion in writedowns since last year, and it dropped down to ninth place with one $423.9 million deal, compared with $31.9 billion in 39 deals in the first half of 07.
On the ABS CDO side, the only activity seen in the sector involves liquidations. "It has become a question of which CDOs are being liquidated and when," the N.Y.-based CDO manager said.
"We have seen over $200 billion in defaults of ABS CDOs in both mezzanine CDOs and high-grade CDOs, mainly because of ratings-based triggers" said Elena Warshawsky, an analyst on the securitization research team at Barclays Capital.
While not all these deals have gone into liquidation, there have been quite a number of cases, she said.
ABS CDOs in default represent 30% by count and 36% by volume of total ABS CDO issuance since 2003. For the 2007 vintage alone, 63% by count and 69% by volume of ABS CDOs issued have tripped EOD triggers, according to analysts from Wachovia Securities.
More specifically, 75 ABS CDOs totaling approximately $82 billion have an acceleration status and 50 issues totaling approximately $32 billion are liquidating or have been liquidated, Wachovia said.
"There are a number of transactions that could potentially go into liquidation. We don't see it yet, but it will come to bear," Warshawsky said.
She noted that it generally takes some time after the event of default before the transaction goes into liquidation mode. "It is not an instantaneous process."
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