Friday, May 18, 2007

Why collateralised debt obligations matter

Nothing, not even steadily rising interest rates, seems to affect one of the most sustained credit booms — and accompanying buy-out frenzies — the world has seen in recent times, says the FT’s Gillian Tett in her weekly Insight column.

But some bankers are now starting to mutter quietly about one risk that is not often discussed — collateralised debt obligations, she warns. They have helped power the credit bubble. And the question now is whether trends in this sector could also now deliver a jolt.

First, however, a quick finance recap: a CDO essentially is a pool of debt assets, in which investors take stakes with different levels of risk, a little like the way mutual funds operate in the equity world. In the last couple of years the sector has exploded, particularly in Europe, where collateralised loan obligations — which buy risky loans — have spread like wildfire.

This, unsurprisingly, has roiled credit markets. The sudden proliferation of asset-hungry CDOs has also raised debt prices, making borrowing increasingly cheaper for buy-out groups. Last week alone, for example, another $4.5bn new CDOs came on tap wanting to buy assets — and another $57.7bn are now in the pipeline, according to JPMorgan.

But now there are ominous rumblings from CDO land. Rumours are circulating that some funds have suffered losses from the recent subprime debacle. While no funds have folded as a result, this has the potential to dent confidence. Tett adds that she has been told some smart money is already furtively creating vehicles designed to feed on sickly CLOs. This week in London, Park Square Capital created a new credit fund which publicly declared that it expects to see a CLO shakeout — and prey on this.

But even without losses, there is another problem that might slow the pace of CLO creation. Their leveraged structure typically promises returns better than traditional fixed income funds, but lower (and more stable) than those of hedge funds. But the maths only works if credit spreads are at a certain level — say, 250-275 basis points above Euribor for leveraged loans with European CLOs.

It used to be easy to get this spread. But demand for debt assets is so high that average spreads are now dropping below 225bp. The CLO industry is killing its own golden goose. This may mean that CLO launches are quietly shelved, or scaled back. In theory, this trend should be self-correcting: if fewer CLOs emerge, loan demand will fall, then spreads will rise and more CLOs will appear.

This benign scenario might play out. But if not, it is entirely possible to imagine a scenario where CLO activity suddenly collapses, producing a shock for debt prices, which could be a tipping point for credit markets that are already overstretched.

The moral is clear: to understand the financial imperatives behind the buy-out boom, do not just blame central bankers (or the Chinese, for that matter). Instead, bone up on the structured finance world as well - with all its alphabet soup.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.