The CLO market has had dark clouds overhead since the credit storm began, and occasionally there have been downpours of liquidations and forced selling. As the storm lingers, market participants differ on their view of the forecast — some believe there will be another wave of liquidations, others believe the market will remain calm.

The most recent liquidations happened during the last three months of 2008, when approximately $5.7 billion in loans were put up for sale, according to Standard & Poor’s Leveraged Commentary & Data. The forced selling slowed down in the first quarter, with only $1.5 billion on the block. However, just over the past several weeks, the number of “bids wanted in competition,” many of them CLO portfolios, has reached almost $1 billion.

Some market participants see this as just the first ripples of a larger wave, and they say it will have a strong impact on loan investors, and, to a lesser extent, high yield bond investors.
CLOs are not only facing depressed prices, but are up against falling recovery rates and weak performance metrics from the underlying assets. The performance of the underlying collateral has been significantly worse than anticipated even a few months ago,

Barclays Capital analysts said in a recent report. Exacerbating the situation is the fact that a lot of CLOs, market participants say, have breached, or are about to breach, their overcollateralization tests, which require CLOs to maintain a certain mix of assets.

The underlying assets in CLO portfolios have been getting slapped with downgrades for a while, but on March 4, in one fell swoop, Moody’s Investors Service put nearly all rated tranches of U.S. and European, Middle Eastern and African cash-flow CLOs on review for a possible downgrade, excluding the most senior triple-A tranches. This action, which applied to approximately 3,600 tranches from 760 deals for a total of $100 billion, is causing those OC cushions to deteriorate.

With all of these factors stacked on top of each other, one might expect nothing short of a tidal wave of CLO liquidations. However, there are market participants—on both the buyside and sellside—who think otherwise.

“There seems to be a misunderstanding that the CLO market is very fragile and that there will be unwinding CLOs, more auctions of portfolios as a result of unwinding, and this never-ending cycle,” said a Boston-based investor. “There is a lot of misinformation out there, and if you had your glass-is-half-empty glasses on, you could read some really bad stuff into these different analyst reports. There are some pretty draconian scenarios, and a little bit of fear mongering.”

Bye-bye Sub-debt Fees

A New York-based banker agrees, “I don’t share the view that CLOs are the next big shoe to drop. Yes, triple-C buckets are going to have another big drop in the market, but [CLO managers] are not going to dump paper because it doesn’t help them that much.”

According to the banker, the group in the eye of the storm, CLO managers, will not be significantly affected by liquidations because they will be one-off events, happening over the next several quarters, much like the liquidations in the first quarter. Still, CLO managers will be faced with the rising number of corporate defaults, and will have to deal with falling subordinated management fees—the fees they collect from subinvestment grade tranches.

“The big crisis for CLO managers is the loss of sub-debt fees,” said the banker. “One guy I talked to, who runs a $3 billion CLO, which is a decent size, said he expects sub-debt fees to be shut off in the second quarter. Their fee mix is 12.5% senior and 37% sub-debt. So when 37% gets shut off, he’s clearly losing three quarters of his fees. … That’s where I think the distress in the loan market will come from. That will result in assets getting moved around to different managers. However, just going out and dumping paper doesn’t save them. The people who dumped the paper before were hedge funds so that they could take their hits and get out.”

Another source added that the disagreement market participants have regarding the CLO forecast is due to the lack of information banks and CLO managers are willing to share. Market participants beyond CLOs, he emphasized, will be dramatically impacted if there is another large scale wave of liquidations. “CLOs represent over 50% of the loan market. If they unwind, I can’t imagine what that would be like,” he said.

What drove the forced selling at the end of last year was the fact that so many CLOs incorporated total return swaps —a  structure that resembles a revolver, but where a swap counterparty, typically the underwriter, retains the loans on its balance sheet. Total return swaps, which were used by hedge funds as a way to access the loan market, have price triggers that require the CLO manager to sell certain assets when the market value of the portfolio falls below a certain point. Bank of America and Citigroup were two firms forced to liquidate portfolios of total return swap CLOs.

The first wave of CLO liquidations happed right around the time Bear Stearns bit the dust. In that instance, the liquidations occurred with market-value CLOs — a type of CLO that differs from cash-flow CLOs because the market price of the underlying collateral, not just the cash-flow generation from the underlying collateral, supports the deal structure. These CLOs, which make up around 10% of the entire $350 billion CLO market, also liquidated because they hit price triggers. During this time, UBS, Wachovia and Citi liquidated more than $1 billion worth of CLO paper.

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