The problems with collateralized debt obligations (“CDOs”) – securities that are linked to the ongoing subprime mortgage implosion – have (appropriately) generated substantial media coverage and (also appropriately) caused a long overdue reevaluation of risk pricing in the credit markets. However, it is the virtual evaporation of the market for collateralized loan obligations (“CLOs”) – securities backed by high yield corporate loans – that is likely to have the greatest impact on the general economy in 2008.
The rise of CLOs has fueled the private equity boom of the past few years and created an easy credit environment that has dropped corporate defaults to historical lows – approximately 1% in 2007, as compared to a historical average of nearly 5% for non-investment grade credits. The buying of bank debt for pooling and securitizing freed up lenders’ balance sheets and permitted the financing of an ever increasing number of deals. Leveraged loans increased from $13.6 billion in 1996 to over $556 billion in 2007, with CLO purchases – virtually non-existent before 2003 – accounting for at least 60% of the market demand over the past few years. Investor demand for CLO paper helped drive down lending costs, which in turn led to larger financings and greater leveraging. Whereas a few years back a corporation was viewed to be highly leveraged if it took on debt equal to 4 t0 5 times earnings before interest and taxes, leverage of 8, 9 and even 10 times earnings became relatively common in the recent frenzied environment.
The music has now stopped, however. CLO issuances have dropped from $127 billion in the first half of this year to $20 billion in the second half. As with CDOs, buyers of CLOs are highly concerned about the quality of the securities that they have purchased. A recent survey of fund managers and institutional investors reflects a high degree of skepticism – barely half indicated that they were comfortable with even AAA rated CLOs. Moreover, only 24% indicated a willingness to buy debt of companies that were leveraged greater than 5 times earnings.
Corporate default rates have so far remained low. However, over $150 billion in leveraged debt will be coming due in 2008. Without CLO demand, banks will once more be exposing their balance sheets to risk, which will in turn drive up lending costs. The easy credit environment has come to an end (for this business cycle). The effects will be felt through all corners of the economy.