Tuesday, June 26, 2007

Another Credit Facility in the New Credit Infrastructure – The CLO

First the WSJ had an excellent article on the CDO market. Now the WSJ reviews the CLO market. I wonder when the WSJ will review the CMO (collateralized mortgage obligations) market?

Below are some of the essentials on CLOs, but the article is worth a read. One question is – will the sub-prime disease in the CDO market spill over into the CLO market. Like guilt by association.

What worries me about all these “new” types of obligations is when an institution is not responsible for the money you lend only the fees you collect, the emphasis changes from good underwriting to money making expediency. There is a lot of difference in the two goals, especially in the willingness to take responsibility for what was done and why.

The corporate buyout boom of the 1980s was funded in large part by high-yield "junk" bonds. This time around, another financial product is supplying much of the fuel -- collateralized loan obligations.

CLOs, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLOs, bankers say.

As corporate borrowing soars, however, concerns are growing that CLOs have made it too easy for shaky or debt-laden companies to borrow money. If economic conditions deteriorate, those loans could sour and investors in the riskiest CLO slices could face large losses. That, in turn, could make it harder for buyout firms to borrow money.

"We are witnessing a loan market rife with liquidity and disproportionate power in the hands of borrowers, arrangers and financial sponsors," said credit-rating firm Standard & Poor's Corp. in a June 13 report.

The past decade has seen headlong growth in markets for various complex financial products, from derivatives to mortgage-backed securities to CLOs. These booming markets are mostly opaque: Investment offerings are private and largely unregulated, trading is sometimes thin, and the securities can be hard to value. That makes it especially difficult to predict what will happen if market conditions rapidly turn unfavorable. . . . At the moment, default rates on corporate loans are very low, . . . . An index tied to non-investment-grade corporate loans fell all last week, according to Markit Group, its administrator. The index, LCDX, was launched one month ago and reached its lowest point yesterday.

Borrowing by corporations has soared in recent years, and CLOs have played a big part. Since 2004, more than $210 billion of loans have been packaged into CLOs, up from $51 billion over the prior four years, . . . . Investors searching for higher yields have put so much money into CLOs that even weak companies can get loans at relatively low interest rates. Last winter, for example, ailing Ford Motor Co. was able to borrow $23 billion in a matter of days, $5 billion more than it earlier planned.

More than a thousand U.S. companies were acquired in leveraged buyouts in 2006 -- a record $194 billion of deals, according to data provider Dealogic. More than $163 billion was borrowed to pay for those buyouts, according to S&P Leveraged Commentary & Data, more than total borrowings for the previous two years of buyouts combined. This year, through mid-June, $103 billion of debt was raised to fund buyouts. Over the next few months, more than $100 billion in loans will be sold to fund mammoth deals such as Cerberus Capital Management's acquisition of Chrysler Group and the privatization of SLM Corp., also known as Sallie Mae.

Many companies are counting on a large investor appetite for the debt to push their deals through. "CLOs are a big pillar of loan demand. If they slow down, borrowing will get a lot more difficult for companies," says Steven Miller, a managing director at S&P.

CLOs have been lauded by former Federal Reserve chairman Alan Greenspan and others for dispersing risk. Michael Milken, whose underwriting of junk bonds at Drexel Burnham Lambert Inc. during the 1980s ignited that decade's buyout boom, has said that CLOs are among the most important financial innovations of the past quarter century.

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