Wednesday, November 25, 2009

The CLO market may be making a comeback

Amazingly, the primary CLO market, which has been shut down since late 2007, may be making a comeback in 2010. The volumes will be a fraction of the peak, the capital structure will be simple, and the equity structures will be thicker, but the deals will get done. Unlike other securitization markets such as ABS and CMBS, it seems that the vast majority of the original AAA tranches will get their principal back in spite of record levels of corporate loan defaults. The AAA subordination of 25-30% has been sufficient to cushion the senior tranches from principal losses. In addition, deals that have had a relatively large portion of their collateral default or get downgraded have been forced to start using income to down the AAA principal, amortizing/deleveraging the transactions early. These facts may bring institutional investors back into the market.

The secondary CLO market spreads have come in dramatically as the chart from Citi/Reuters shows.

In order for the primary CLO market to work, the spread between the leveraged loan yields and the AAA tranche rate has to reach a level that will make the "excess return" attractive. As an analogy, consider what happens if you were to buy a rental property. If the monthly payments on the loan you take out is higher than the rent you collect on the property, you would never buy the property. In fact the differential between the rent collected and the interest expense on the loan has to be attractive enough to make you want to put down a downpayment on the property. In this analogy the CLO equity tranche is the "downpayment", the AAA tranche is the mortgage on the property (with lower rated tranches being "second mortgages"), and the collateral portfolio of corporate loans paying interest representing the property paying rent.

To make the equity returns work, one needs a relatively low financing spread ("mortgage rate") and a sufficiently narrow equity tranche (the "downpayment"). The chart below illustrates the expected return levels (roughly) as a function of the financing spread (blended spread of all the tranches above the equity).

The three lines represent the different equity tranche thickness ("downpayment"). As the AAA tranches continue to tighten in the secondary market, at some point the return on equity starts to make sense for some investors and the new transactions would get done. This may be the first securitization market that comes back (even as a shadow of what it used to be) without government (TALF) assistance.
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