The predicament of primary loan book hedging
WHO WOULD WANT to be a bank credit portfolio manager in the fourth quarter of 2007?
Fear has led to substantial reductions in liquidity in the cash bond, loan and CDS markets, leaving banks scrambling to manage their leveraged loan exposures and assess the damage in their structured credit positions.
Credit portfolio management groups have been preparing themselves for the bad times since banks pulled themselves out of the last recession, which was marked by several high-profile corporate defaults. Having learnt the painful and expensive lessons of Enron, WorldCom and the like, many banks established credit portfolio management practices to hedge their multi-billion dollar and euro corporate loan books and avoid the losses sustained in previous downturns.
Have the lessons been learnt? Are the techniques they have developed robust? Although the art of credit portfolio management isn’t new, it just got much harder as the golden age of credit came to a shuddering halt, hastened by the collapse of the US sub-prime market.
Deutsche Bank, Morgan Stanley, Citi, Bank of America, ABN Amro, UniCredit, Barclays Capital, JPMorgan, Dresdner Kleinwort and Société Générale are among the early adopters of credit portfolio management techniques. Major Japanese banks are building credit portfolio management groups and second-tier European and US banks have also installed teams.
It had been a good time to get into credit portfolio management. Until recently, tight CDS spreads on single names and the indices meant that buying protection was cheap. As banks grew their loan books, their hedging activities grew with them. In 2005, Société Générale took advantage of tight CDS spreads to increase the hedging on its €135 billion loan book from €8.5 billion in the first quarter to €15 billion.
According to its annual report for 2006, Citi has a $630 billion corporate credit portfolio, $93 billion of which was hedged. And as of year-end 2006, Deutsche Bank’s loan exposure management group held credit derivative positions with a notional value of €24.8 billion and had mitigated the credit risk of €13.4 billion of loans and lending commitments using synthetic collateralized loan obligations (CLOs).
The credit crunch means that hedging loan books has suddenly become a lot trickier than it was just a few months ago. A lack of liquidity in the CDS markets had made hedging with single-name CDS difficult. In addition, demand for loan assets has dried up almost completely, making the transfer of risk using CLOs nearly impossible. So what have credit portfolio managers been doing?
"In these markets we couldn’t do anything but the very basic, because of liquidity," says Thomas Bretzger, managing director at UniCredit Markets and Investment Banking in Munich and head of its active credit portfolio management group. "We are doing [CDS] index trades. The indices are still liquid and the bid-offer is small."
Wider spreads
Single-name CDS that used to trade with sufficient liquidity to put on positions $50 million to $100 million in size are now getting done in the $5 million to $10 million range, say portfolio managers. And trades that used to take only a few hours to complete now take a few days. Lately, some liquidity has returned to the CDS market but at much wider spreads.
"The problem right now is with liquidity," says a credit portfolio manager at a big German bank. "There is a huge overhang of new issuance coming in both loans and bonds and no dealer wants to take on any additional risk on their books. So the fact is they’re not acting like dealers by providing liquidity to the market."
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"What we’re going to see is the same thing we’ve seen in previous cycles, all of a sudden in a crisis people get religion and say we need active portfolio management – and that’s probably the most expensive time to do portfolio management"
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ABN Amro’s James Lentino, an executive director in the capital management group in Chicago, adds: "We haven’t been prevented from doing anything we’ve wanted to do in our hedge book. It’s case by case, name by name. Certainly some of the liquidity has come out of the market. You just have to be aware of that and give yourself more time. Trades that might have taken a day to do, now might take a few days."
UniCredit was able to get a €6 billion CLO priced just before the market shut at the end of June. "We were lucky," says Bretzger of the Euroconnect deal that comprised loans from Italian, Austrian and German corporates. UniCredit’s deal might well be one of the last jumbo CLOs to get done this year as the market has all but died since investment banks such as Bear Stearns began to reveal the extent of their sub-prime exposure. Overall global CLO volumes (synthetic, arbitrage and balance sheet deals) had been forecast to be about $120 billion in 2007, but no one believes that level will be reached until the credit market’s fortunes change dramatically for the better.
Not all bad news
Wide CDS spreads are not necessarily bad news for credit portfolio managers. Now their short positions, which had been posting losses in the good times, are in the money. That means many loan book hedgers have taken the opportunity to lock in profits.
"We put on hedges when spreads were tight and have taken some profits but there are cases where we’ve added hedges depending on what we think is cheap or rich," says the credit portfolio manager.
Some feel the market downturn is overdone and the fundamentals are such that there isn’t going to be a recession. The spread widening in CDSs could well be overblown and likely to rebound and tighten, making a good case for taking profits when the chance is there.