The psychology of it all

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We have suffered through a difficult three months in the global credit markets, with risk repricing across the board and liquidity disappearing in nearly the blink of an eye. To give you an idea of how quickly things unravelled, one only needs to look at the major European high-yield proxy, the iTraxx Crossover Series 7 index. The iTraxx hit a closing-day low of +189 on June 1, and within the space of only two months, hit a closing day high of +463 on July 30 as the markets worsened dramatically over this period.

The damage inflicted on CDOs that were holding subprime assets was severe, as investors in the tranched debt were left facing losses, even on the highly rated tranches of these vehicles.

To say this came as a shock is an understatement, and the contagion quickly spread from just CDOs holding subprime assets to the entire CDO market, also engulfing the large number of funds holding leveraged loans and high-yield bonds. Confidence in the rating agencies' assessment of the tranched debt of CDOs diminished quickly, plunging the entire CDO market - once one of the hottest and fastest growing new categories of credit buyers in the market - into a state of despair.

The buying power of this investor base seemed to evaporate almost overnight, leading to a rapid remarking of leveraged loans in the secondary market. Most cash loans moved into the 95 area context by late summer, as did the major leveraged loan index in Europe (the LevX).

The fall in secondary prices of leveraged loans also negatively affected credit hedge funds that had relied heavily on short-term financing to 'turbo-charge' their returns, effectively neutering yet another material segment of buyers of credit. These funds found themselves unable to access short-term liquidity just at the time that their underlying assets were losing value, a phenomenon that caused a death spiral for many of these funds.

The decline in prices of LBO debt also caught many banks holding significant amounts of overpriced and unsaleable LBO debt. Under these conditions, the substantial forward calendar of new LBO debt which was building in the spring, estimated to be over US$300 billion, suddenly became formidable. Together, these circumstances led to a withdrawal of liquidity from the credit markets, bringing the primary and secondary markets for leveraged loans and high-yield bonds to a virtual standstill.

At the time of writing, sentiment is trying to improve off of the Fed's 50bp cut in the Fed funds rate on September 18. However, the near-term outlook is tenuous at best, as many of the concerns troubling the credit markets are simply not going to go away overnight, including the overhang of a huge new issue calendar, growing conviction that the default rate will increase, and the disappearance of a significant amount of liquidity that has no reasonable chance of being replaced in the near-term.

As always, psychology has played an important role in this malaise, and any return to normality will first depend on a return of investor confidence and improvement in sentiment. Let's look closer at the psychology.

The psychology of investors

Although the effect of the credit meltdown on CDOs has been perverse, severe damage has also been inflicted on the working models of credit hedge funds and banks that have been aggressive buyers of LBO-related loans and bonds. Investors in publicly traded high-yield bonds are generally more accustomed to dealing with day-to-day fluctuations in the prices of bonds in their portfolios. However, the principal investors in leveraged loans - banks, CDOs and credit hedge funds (along with their margin lenders) - had become accustomed to believe that loans were an asset class which, barring specific credit events, would always remain at par or above. Why? Because this had largely been the case for several years, a period over which almost all leveraged loans traded at the break in the secondary market to above par.

In the frenzied competition to get good allocations by an ever-growing number of funds and banks interested in owning higher yielding credit assets, accommodations were made in terms of leverage (higher, leaving less room for margin), pricing (lower) and covenants (looser). So with this backdrop, and given the relatively short history of a 'liquid' secondary leveraged loan market in Europe in any event, investors were caught off-guard when secondary loan prices began to slip below par.

Although investors in the high-yield bond market were more accustomed to price gyrations, the rapid one-directional repricing of risk also caught them off-guard as high-yield bonds gapped down indiscriminately, by 5 to 15 points in price. This happened so quickly that price transparency in the secondary market simply evaporated, and trading in individual cash names ground to a halt. Very wide bid/ask spreads on cash loans and high-yield bonds reflected the difference in views between sellers, who were finding it difficult to accept the significant and painful repricing of their assets, and potential buyers, many of whom believed things would get worse before they got better.

New issue activity will not resume until the two constituencies - buyers of credit and sellers of credit - get on the same page as far as the price of non-investment grade rated assets is concerned.

The psychology of issuers

The non-investment grade rated loan and bond market can be divided into LBO-sponsored debt and corporate debt. It is the former that is causing the most concern today. Private equity funds took advantage of the abundance of cheap credit over the last two years to do larger and larger transactions, and underwriting banks willingly supported these 'elephant hunts' on the basis that bigger transactions generate bigger fees.

It is hard to blame the private equity community: they were not only competing amongst themselves, but also with corporate buyers for trophy properties in order to deploy their wall of cash. The willingness of banks to agree to higher and higher leverage multiples meant that the sponsors could pay higher and higher prices for targets without eroding their returns.

But the music has stopped with the evaporation of cheap and abundant credit. The tighter environment for credit will force leverage multiples down and pricing of supporting debt up, accompanied by tighter terms. There will be fewer transactions. Until the existing forward calendar of LBO-related debt is fully digested, LBO activity will not return to any sense of normality. Private equity sponsors will be reluctant to let their banks off the hook (fair enough), and so the market will only resume, gradually, when underwriters begin to painfully recognise that they must part with underwritten assets at significant losses, and investors agree on a clearing price at a level that ensures them limited downside price risk.

With this backdrop and as a specific comment related purely to the bond market, the expectation is that smaller issues by below-investment grade rated corporates (as opposed to large issues from legacy LBOs) will likely reopen the high-yield market, acting as a precursor to attempts to place LBO-related high-yield bonds.

The psychology of underwriters

It is clear now that many banks have been caught red-handed with large amounts of unsold and overpriced legacy senior loan and bridge loan underwritings. The pain of markdowns is already beginning to become visible as the larger underwriters of leveraged transactions begin to report their results. This clearly will have an effect on risk policies at most banks, inhibiting their ability to enter into large and aggressive underwritings in the foreseeable future. Moreover, the reduction in new LBO transactions - the most significant driver of leveraged loans and high-yield bonds - will mean that many of the more active banks in leveraged finance will have to reduce staffing levels as they 'right-size' in anticipation of more modest activity in leveraged finance in the near future.

Conclusion

We can do little about where we are today, but understanding the psychology of the various constituencies will be paramount to getting the leveraged financing market back to normal. This will not occur overnight, but rest assured, it will eventually occur - it always has.

Less sophisticated credit investors, including buyers of loans for structured funds, have been wiped out, but this is normal as excesses have to be washed away. The sell-down of legacy risk is starting to occur, as the 'new' clearing price of 95-96 on pre-crisis loans gradually becomes a reality.

Although there will be further markdowns and losses for underwriting banks on legacy underwritings, we are likely to be left with banks that are in generally good condition, and their pain - while severe - is likely to be short-lived. Private equity funds still have record levels of funds to invest, and after all, companies do still need money. It is time to look forward.

Tim Hall is head of global high yield and emerging markets at Calyon

Tel: +44 (0)20 7214 5786

www.calyon.com

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