The rise of leveraged loans

Standard and Poor’s in particular took issue with my argument. Steve Miller, of S&P Capital IQ’s Leveraged Commentary & Data, published a response on Forbes.com entitled “Leveraged loans: Fortune’s CLO Criticism — The Numbers Tell a Different Story.” In it, he cites “several factual errors in the story.” In fact I did make one small technical error, which is now corrected and noted in the piece, but otherwise it appears that my differences with S&P are differences of opinion, not factual errors. (S&P LCD is a subsidiary of Standard and Poor’s, one of the ratings agencies assigning AAA ratings to these financial products.)

For a quick refresher, a CLO is a type of debt security in which high-risk commercial loans are bundled together and sliced into pieces for sale to investors. The point of this “bundle and chop” is to disperse risk. Investors looking to dial up the risk (and the potential reward) can take the riskier part of the CLO while others, like insurance companies and pension funds, can take the less risky parts. By spreading out this risk, companies that couldn’t otherwise get financing because of bad credit now stand a better chance of getting a loan.

I had argued that the CLO market today poses some of the same risks as the collateralized debt obligation (CDO) market did before the housing crisis. The crux of S&P LCD’s argument is that the good stuff in these CLOs rarely, if ever, fails:

“According to S&P Ratings, the cumulative default rate on U.S. CDO obligations originally rated AAA (since 1996) is 14%; those include deals that bundled sub-prime mortgage backed securities. The comparable measure for U.S. cash-flow CLO liabilities originally rated AAA, by contrast, is zero … Thus, the Fortune piece — by comparing CLO default rates with those of CDOs — is, in effect, calling an ant hill a lesser peak than Mount Everest.”

But the ratings agencies made the same claims about the CDO market before it imploded in 2007. Those numbers also told a different story than anyone sounding alarms was telling: Mortgage-based structured credit vehicles also “rarely, if ever,” went sour. Housing prices always went up, and people rarely walked away from their houses, or so the argument went. And we all remember what happened next.

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So, is the CLO market going to blow up tomorrow? Probably not. But the CLO market is no different than any other market — if it gets too hot it will eventually overheat. That’s not to say that CLOs are inherently bad, but when you are dealing with leveraged loans, the result may not be as pretty or as predictable as you may want to believe.

Today, leveraged loans and junk bonds are taking on the role that housing played during the credit crisis. Increased demand for yield has translated to a lowering of basis risk to such a degree that junk bonds and leveraged loans are being issued at a remarkably low 5% yield. Some of those loans are ending up in CLOs and sold to investors who want a little more yield but are hamstrung by investing mandates to buy only triple-A rated securities. A whopping $83 billion worth of CLOs were issued in 2013, up from the $3 billion issued in 2009.

We seem to be at a crossroads in the latest credit cycle where the chances of such a blowup may not be too far off. Triple-A rated CLO tranches could very well keep their nearly perfect AAA batting average, but it is just as likely that things could take a turn for the worse — and fast. That’s because, regardless of how a CLO is structured or whether it is actively managed, if the quality of the underlying asset is bad, the game is over.

There are signs of a reversal in the market already. An analysis conducted by Moody’s found that credit quality in new U.S. CLO transactions has “deteriorated” since April 2012 due to an increase in the proportion of B3 rated loans. B3 is six notches below junk, making it super-subprime. Banks are not only structuring riskier CLOs, but they are also holding on to fewer of those securities. Banks now make up just 42% of the buyers of new triple-A CLO tranches, down from 90% last year.

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I went back to S&P LCD for more clarity around their argument that this market poses no resemblance to the CDO market that nearly crippled the U.S. financial system. “Your central point is right, credit cycles typically move from low default rates, high fear, high risk-return, to a point where deals get excessive,” Miller told me. “Then, when a recession hits, some over-levered issuers are forced into bankruptcy, bringing on a default spike — that’s time-honored tradition.”

Miller believes that we are probably in the middle of the credit cycle at this point and that it’s premature to be sounding the alarm. One of the ways S&P LCD gauges market exuberance is to analyze the leverage ratio of the deals getting done. The leverage ratio shows how much debt is being piled on to the company to take them private. The larger the debt load, the greater the chances of default. So far, Miller says, it hasn’t reached worrisome levels, but he admits we may eventually get there.

So perhaps Miller and I agree on the fact that the risk exists, but disagree on the approach the financial industry should take to mitigating that risk today. How bad it will get is pretty much anyone’s guess. But to dismiss these clues would be similar to burying one’s head in the sand.