Leveraged finance: Leveraged finance goes from bad to worse


Louise Bowman
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Far from turning a corner in 2008, the market looks set for a few tough months yet.

"January is going to be a horrific month for losses," said a leveraged finance banker at the end of the month. "In December all I was hearing was that in the New Year everyone would have new budgets and new lines, and everything would be OK. But people are now finally waking up to the fact that things are going to be miserable in this market for some time to come."

The market remains plagued by the dual problems of the hung pipeline and the evaporation of the institutional bid for leveraged loans. As each month passes, the pressure on bank balance sheets continues to grow and there is a sense that the situation must come to a head soon. Forced selling has begun, but is just contributing to further price declines. According to Standard & Poor’s Leveraged Commentary and Data, the average loan spread at the beginning of February was 535 basis points over Libor – which is a full 295bp above its traditional 240bp level. S&P concludes – not surprisingly – that spreads now offer a true margin of safety over and above default risk even if there is a severe macroeconomic downturn. Surely then it cannot be long before buyers return to the market?

Unsold inventory

"Investors can see the value on offer but are staying clear," said Siobhan Pettit, head of structured credit strategy at RBS, in early February. "Loan investors are seeing loans trade lower by the week and fully expect prices to fall further still. The size of unsold inventory is unbearably large versus absent CLO demand." Investors that bought into the leveraged loan market when prices hit the 95 mark have just watched as levels have fallen further. Until buyers can be confident that there is not another round of bloodletting to go they will sit on their hands. "We did see people starting to buy in Europe at the low to mid-90s in January but then the market was hit with unwinds from market value and TRS CLOs which had breached their triggers," Rishad Ahluwalia, head of European CDO research at JPMorgan, tells Euromoney. "We will see more of these vehicles owning up to losses on the market value side, which means that volatility will continue." However, Gerard Charpin at UBS puts this in context. "CDOs, except for a few CPDO type structures, are not mark-to-market so do not become forced sellers if spreads widen," he notes. "Although extremely depressed valuations could get some holders to throw in the towel, we believe this should remain a minority, provided the rating agencies do not rattle their cage too loudly."

Risk appetite

JPMorgan CDO client survey

Source: JPMorgan

Despite this it is hard to imagine sentiment – particularly in the leveraged finance market – getting much worse. "This is going to be a miserable year in leveraged finance and people are going to do stupid things," one banker predicts. "But at some point someone is going to buy a large chunk of these loans." Two institutions that seem to have been doing just that are the Carlyle Group and Goldman Sachs, which were working on a bumper European CLO as Euromoney went to press. The €2 billion deal is being backed by collateral purchased below par at around the low 90s level. €1.47 billion of the deal will be triple-A, €85 million double-A and €90 million single- A minus. There will also be a €70 million triple-B minus tranche, a €50 million double-B minus piece and €80 million of single-B minus notes.

Launching such a huge trade into the present market is highly ambitious, particularly given that the traditional buyers of triple-A CLO paper – the SIVs – are probably otherwise engaged. "The number of investors that are now in a position to buy triple-A CLO paper can be counted on the fingers of one hand," muses one observer. But maybe the lure of 150bp for a very short four-year weighted-average life will be enough to tempt them. "We buy tranches of CLOs and it is hard to find paper from good managers that is cheap," says a US asset manager. "There is not a big discount on CLO paper the way that there is on CDO paper."

Getting a deal of this magnitude done in Europe would certainly be a much-needed fillip for the market. There have been a few deals trickling through each month: in early February, Citi brought a $750 million CLO for Silvermine Capital Management with the triple-A piece pricing at 85bp over three-month Libor. Double-A paper was offered at 300bp and single-A at 400bp. But the market is a long way from fully functioning. "The technical impasse in the market is multifaceted," says Ahluwalia. "It is a chicken-and-egg situation. If you manage to sell a CLO now you are locking in a very high cost of funding, and what happens if and when spreads tighten in?"

Spread instability

JPMorgan recently polled more than 200 of its CDO investor clients and found that the greatest impediment to more active participation in the CLO market is spread instability. This, together with headline instability, accounted for 58% of respondents’ reasons for not buying. But a surprising 38% of respondents said that they were looking to maintain their CLO exposure over the next 12 months, with 27% looking to increase it by up to 20%.

But for that to happen the leveraged loan market has to get moving again. "The banks with the overhang are the arranging banks, not the participating banks," points out one banker. "There is plenty of capacity out there to buy loans, it is just a question of when." But it might not be soon. "But there could still be tens of billions of write-downs to go." According to JPMorgan, while $150 billion to $200 billion has been written down so far, this could eventually reach $300 billion.