We pretty much know where we stand with CDOs. So what of CLOs?
That is, collateralised loan obligations - a close relative of the CDO based on a portfolio of loans, rather than ABS.
The Wall Street Journal made a foray into CLO territory on Monday. And Felix Salmon rightly asks, should we be worried?
CLOs are indeed a cause for concern. Not, perhaps, in a subprime-RMBS-AAA-noteholders-wiped-out way, but more in the way that all banks are vulnerable right now to further writedowns and capital constraints.
The CLO market isn’t anywhere near as big as that for CDOs, but at $350bn, it’s big enough. CLOs have been used by banks as buyers for massive leveraged buyout loans - big baskets into which to easily syndicate.
Leveraged loans, however, are trading at big discounts. As the FT’s Lina Saigol wrote on Monday, 80 is the new 90 when it comes to leverage loans trading below par. In some cases, senior loans like that for ProSieben are trading as low as 73. By way of an average, the benchmark LCDX index, which tracks CDS on 100 US corporate loans, fell to an all time low of 90.8 on Monday, closing at 90.20.
For one particular breed of CLO, that’s particularly troubling. Market-value CLOs have triggers written into them which force an unwind if the value of their loan portfolio (or the portfolio of swaps on those loans in the case of synthetic CLOs) dips below a certain level. For portfolios of mezz loans, the trigger is typically at around 30 per cent. For senior loans, a typical trigger point is around 12 per cent. With the LCDX where it is, it shouldn’t be surprising then, that some market-value CLOs have already begun to liquidate.
Liquidation of the $430m CLO Aladdin LETTRS Fund, (arranging bank Barclays), began on Monday. And Hartford, a even bigger CLO with a $1.5bn portfolio (arranged by Citi) is also thought to be liquidating.
Market-value CLOs are only worth about $35bn in total, so the direct threat to banks from them isn’t huge. But the systemic risk is significant. As market-value CLOs liquidate, and are forced to try and sell their loan portfolios, they will in turn depress prices in the loan market as a whole, and thus impact significantly on the value of notes in the broader non-market-value CLO universe.
All of this wouldn’t be too troubling for banks, was it not occurring at the same time as another financial market crisis - that with the monolines.
In arranging CLOs, it was banks who typically bought the AAA tranches. Around 90 per cent of CLO AAA tranches, in fact, are held by banks. The lower rated, higher-yielding tranches were the ones institutional investors, like hedge funds, wanted. So in part, banks’ buying up the AAA paper was just a facilitator.
Hitherto, banks haven’t really mentioned their CLO exposures, because they have been, in net terms, erased from balance sheets using negative basis trades. So while banks may have huge gross exposures to CLO paper, it hasn’t been an issue, because these positions were, from the outset, fully hedged.
Hedges with monolines.
Thus as monolines totter, banks are having to writedown the value of the CDS, and so add CLO exposures onto their balance sheets. Just at the wrong time - as CLOs’ paper becomes more distressed. While losses won’t be realised as severely as with RMBS, rating downgrades to CLO paper may well require banks to stump up extra regulatory capital at a time when they can least afford to.
