Rising from the ashes

Collateralised loan obligations


Structured credit products suffered horribly as the subprime mortgage problems in the US spread throughout the capital markets in the second half of 2007. Soaring delinquencies in US subprime mortgage loans were followed by mass downgrades of collateralised debt obligations (CDOs) and constant proportion debt obligations, falling valuations in the secondary market and a squeeze in liquidity. But new openings in the synthetic collateralised loan obligation (CLO) market may bring a welcome chink of light to the gloom enveloping the sector.

With much of the structured credit market still closed, banks such as Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers and Morgan Stanley are turning their attention to synthetic CLOs. The first transactions have already been launched, and dealers expect more to follow over the next few months.

One of the early movers has been The Carlyle Group, whose European leverage finance group closed a managed synthetic CLO in December. The EUR300 million deal, called CELF Synthetic Loan Partners (CSLP), was arranged by Goldman Sachs and comprised two tranches of notes - AAA and equity. The notes are referenced to two segregated portfolios of loan credit default swaps, which will be managed separately. Further taps of this facility are expected this quarter (Risk January 2008, page 51).

Dealers report they are in consultation with other portfolio managers about new synthetic transactions. With little going on elsewhere in the structured credit markets, some participants suggest banks are under pressure to get synthetic CLO deals out of the door. "Managers need to do a couple of deals this year to keep their lights going, and that is putting pressure on them. It has made them more than willing to look at the synthetic market as another avenue of doing transactions," says a credit trader at a major investment bank.

Much of the catalyst for the growth of the synthetic CLO market has come from the very event that has caused the rest of the structured credit market to dry up - the subprime crisis. Throughout 2005 and 2006, the leveraged loan market experienced an unprecedented bull run, driven by high demand from investors for cash CLOs. A scramble by CLO managers to source loans in a tight primary market caused spreads to squeeze in, while a lack of supply forced many to turn to high-yield and so-called covenant-lite loans (where traditional maintenance tests are removed from the loan documentation).

However, the blow-out in spreads and drying up of liquidity in the third quarter of last year meant CLO arrangers were left with huge mark-to-market losses on their leveraged loan warehouses. It can take several months to ramp up a cash CLO - and, when the tide turned in August, a number of dealers were caught holding hundreds of millions of dollars in leveraged loans intended for forthcoming CLOs. Citi, for instance, reported a $1.35 billion write-down on funded and unfunded highly leveraged finance commitments in the third quarter, while JP Morgan had write-downs of $1.3 billion.

"My own view is that warehousing risk is a risk that people in general put on too lightly. I think there has been a shock and this has made people aware of the risks involved in what they were doing. For me, that is a permanent transition," says Jonathan Slater, global head of credit exotics and hybrids at JP Morgan in London.

With banks less keen to maintain hefty leveraged loan warehouses, synthetic structures are becoming more attractive - not least because arrangers and managers can ramp up deals in a fraction of the time. Arrangers have been helped in this by the steady improvement in liquidity in the underlying loan credit default swap (LCDS) market over the past six months.

"We are of the view that there are lots of opportunities in synthetic CLOs. It is clearly tougher to do the traditional cash loan deals, and a lot of the technology that has been developed around corporate CDS underlyings in the CDO space is almost directly applicable to loan CDS underlyings," says Slater.

Development of the LCDS market has not been without challenges. Dealers initially disagreed over the wording of documentation, which hampered liquidity. In particular, traders argued over whether LCDS contracts should be callable - in other words, whether a contract should be terminated if the underlying loan to which the LCDS is referenced is refinanced.

Following months of debate, the International Swaps and Derivatives Association unveiled standardised documentation for US single-name and index trades last May, which stipulated that if the underlying loan is repaid, the contracts will be callable within 30 days only if a replacement obligation cannot be found. This was accompanied by the launch of the Markit LCDX index - which comprises 100 equally weighted North American LCDSs referencing syndicated first-lien loans.

Then, in July last year, Isda published revised single-name European LCDS documentation, which gives users the option of whether the LCDS contract will be cancelled after the refinancing of the reference obligation. This was expected to give a fillip to the existing Markit LevX indexes, which had seen only slim trading volumes since their launch in October 2006. The LevX senior index references the 35 most liquid first-lien corporate loan CDSs traded in the European market, while the LevX subordinated index references 35 second- and third-tier loans.

Volumes in underlying LCDSs have leapt as a result - particularly since August, when liquidity in the cash loan market dried up, say traders. "During the crisis in the third quarter, a number of loan players not traditionally involved in derivatives markets were forced to direct themselves towards LCDSs, given that the cash market was not operating normally," says Sanjay Jhamna, head of exotics trading at JP Morgan in London. "It is certainly the case that the number of names, size of trades and bid/offer spreads are now more in line with corporate CDS-equivalents than ever before."

This has also contributed to a shift in the basis between cash and derivatives. LCDSs are currently trading 40-50 basis points tighter than cash loans, encouraging some investors to put on relative-value trades. Market participants estimate this negative basis was consistently around 100bp before the crisis in August 2007. "There are definitely some interesting relative-value positions that people can put on using synthetic loans. If you simply look at the high-yield market versus loan tranches as a relative-value play, overall these things do help add liquidity because they provide other players that are interested in putting on some positions in loan tranches," says JP Morgan's Slater.

The improvements in liquidity mean arrangers now have a universe of LCDS names that can be incorporated into synthetic portfolios. At the same time, the launch of tranches on the Markit LCDX index in the US has set the scene for the emergence of bespoke, single-tranche synthetic CLO deals, argue some dealers. The LCDX index tranches were launched last October, with demarcation limits set at 0-5%, 5-8%, 8-12%, 12-15% and 15-100%.

"Given the increased reluctance of banks to enter into warehouse facilities and investors to commit, there is an enormous premium on an execution mechanism that gives you flexibility to be able to meet individual needs as they come along, and that is obviously the strength of the single-tranche business model," says JP Morgan's Slater. "Investors can be guaranteed execution at the point they want to commit, rather than having to sign up to a large syndicate process."

Others, however, are focusing on selling full capital structure deals, with some dealers pointing out the LCDS market still isn't liquid enough, particularly in Europe, to support delta-hedging of single-tranche transactions. "We don't think the European market is ready for a single-tranche transaction where you apply bespoke technology to use on CDS underlyings, simply because we believe the European loan CDS market is not that liquid right now. From a hedging perspective, the investor ends up paying a lot of money on that risk," says Ashish Keyal, a credit analyst at Lehman Brothers in London. "Also, the loan market isn't broad enough to choose that many credits for a single transaction."

Dealers are currently in consultations about further developments to the market - for instance, standardised tranching of the LevX index is expected in the second half of this year. But it may take some time before there's sufficient liquidity to sustain a burgeoning European single-tranche synthetic CLO market, adds Keyal: "In the European market, we strongly believe that it makes a lot more sense to do full capital structure transactions rather than single-tranche, because to a large extent you eliminate complications about computing and pricing correlation. Liquidity does not support bespoke activity right now."

Although there is cautious optimism about the development of the synthetic CLO market this year, a crucial factor determining the level of activity will be the level of defaults. Dealers point out that, despite the subprime crisis, the fundamentals of the loan market remain robust. Nonetheless, any deal - whether single-tranche or full capital structure - is likely to include a manager to assuage investor concerns about credit deterioration.

"The model is broken for cash CLOs. You simply can't access the collateral and the AAA and AA spreads on the liability side are too expensive for the structure to work," says a senior banker at a US investment bank. "Given the market disruption at present, we do see a lot of interest in managed structures from investors on the synthetic structures as a result."

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