According to a Morgan Stanley report, some of the new collateralised debt obligations (CDOs) issued in March were due to the restructuring of transactions that were previously market-value collateralised loan obligations (CLOs), but were downgraded or hit liquidation triggers. All of the March CDO issuance was in leveraged loan CLOs ($11.4 billion) and middle-market CLO transactions ($2 billion). “At least one transaction might have been structured to take advantage of the PDCF financing,” the Morgan Stanley analysts said. Some other CLOs priced this year are based on loans that have been warehoused since mid- to late 2007, the report said.
Among the largest CLOs created this year has been the Lehman Brothers $2.8 billion Freedom CLO, based on loans that could not readily be sold to investors, such as those for buyouts of Colorado-based payment processor First Data and Texas-based power producer TXU. Parts of the First Data loan were offered at a 4% discount in September 2007, and several other banks have since followed suit, selling off buyout loans at deeper discounts to improve their balance sheets.
CLOs have traditionally been used to securitise loans used to finance leveraged buyout deals, as this enables banks to sell commercial loans - or in some cases, the credit risk associated with such loans - directly into markets, offering banks a means of achieving increased liquidity. But in the absence of a liquid public market for CLOs, banks are relying on the Fed as a buyer of last resort, the report suggests.
Investment banks still have large amounts of buyout debt issued last year on their balance sheets. Some might be trying to back out of deals they originally committed to finance, as in the case of the buyout of US media group Clear Channel, where Boston-based buyout firms Bain Capital and THL are chasing after six banks they accuse of balking at commitments to fund the $26 billion takeover. With the structured credit market grinding to a halt in the third quarter of last year amid rising defaults in the US subprime mortgage sector, banks have been limited in their ability to move these leveraged loans off their balance sheets to avoid further writedowns.
The PDCF facility, launched on March 16, helps alleviate this problem. The facility provides overnight funding to primary dealers in exchange for a specified range of collateral, including investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available. The facility is, however, not set up to accept the non-investment grade corporate debt, which makes up some of the underlying of these new CLOs.
However, passing on this debt to the Fed creates a problem for US taxpayers, who will suffer for the loss of value in these assets as conditions in the market continue to deteriorate. Financial institutions have continued to suffer massive writedowns in the values of their assets, with the International Monetary Fund estimating that the losses could reach $945 billion.
However, these new deals might signal the end of the CDO issuance freeze, Morgan Stanley said, although the issuance level in the first quarter of 2008 is still well down on a year ago. The bank estimates total issuance between January and March 2008 of $16.7 billion, made up of 21 deals, down from 236 transactions totalling $165 billion in the first quarter of 2007.