INSIGHTS

Revived interest in CLOs helps bank detox job

LONDON, Oct 20 (Reuters) – Rising prices and a hunt for yield are driving renewed interest in collateralised loan obligations (CLOs), signalling that the task of detoxifying banks’ balance sheets is gradually becoming easier.

“The CLO market is clearly waking up,” said Neal Neilinger, vice chairman and CIO of Aladdin Capital, a firm that used to be one of the biggest managers of CLOs before the crunch.

The opaque and complex investment vehicles, which collapsed with the onset of the credit crunch, are now yielding spectacular returns for specialist investors, with some of them nearly doubling their value so far this year. “The whole idea was to take advantage of the fact that the market had punished even those deals that were able to be understood,” said Neil Basu, at Pearl Diver Capital.Pearl Diver started investing the proceeds of its $150 million distressed CLO debt fund at the start of the year, Basu said, and the fund has returned a little over 80 percent so far.
CLOs gave investors access to leveraged loans in the form of a security. They were also a popular tool for the lenders to offload risk to the capital markets and a driver of the private-equity buy-out boom up until mid-2007.
Prices for leveraged loans in the secondary market have shot up this year after their virtual collapse two years ago. The recovery in the underlying leveraged loans is now feeding through into the valuations of the different layers of the tranched CLO structures. Investors said that this strong performance had made it easier to trade both loans and CLO securities.
PRICES
The International Monetary Fund estimates that banks will need to recognise a further $1.5 trillion in write-downs on securities and bad loans, after losing $1.3 trillion through the first half of 2009.
Higher secondary market prices for loans and CLOs would help reduce the pain, and contribute to write-ups.

At the start of the year, average prices on leveraged loans were trading at 62 cents in the dollar. They are now up at 93 cents in the dollar, said Aladdin’s Neilinger.
There is a better balance to the market place, with less one-way flow from forced sellers and a wider range of investor interest. “We have seen a lot of activity for mezzanine notes of CLO. It’s a real two-way market.There is a lot of opportunity in that space,” said Andrew Donaldson, CEO of Credaris, a specialist credit investment advisor.

For reasons of accounting or valuation, the tranches senior or junior to mezzanine still do not trade as frequently.
EXOTIC
Pearl Diver’s Basu spent much of his recent career at Nomura , arranging and structuring some of the more esoteric deals before moving to Wachovia.
His plan was to try to establish a European flow CDO operation at the U.S. bank, which was already a big player in the structured credit sector in its domestic market.
Then the crunch hit and Basu and his team raised money from private quity and institutional investors who recognized that there was a signficant opportunity opening up in the CLO sector.

Like many other former participants of the structured credit markets, Aladdin Capital has had something of a reinvention. The former specialist alternative investments player has since transformed itself into a boutique investment bank with an advisory and broker dealer operation.

HUNG LOANS
Some banks are using the new-found positive sentiment in the CLO market to off-load hung loans from their balance sheets, acquired when the CLO market suddenly shut tight following the general collapse of confidence in structured credit.

At present such deals are typically re-securitizations where CLO tranches are carved up for various reasons, such as alleviating mark-to-market volatility or ensuring eligibility for repo funding with the European Central Bank.
It was a record September for activity, according to analysts at Citi. Nearly $2.5 billion of public bid lists were circulated, making it $8 billion since April. The full level of activity is probably higher as a lot of trading is private.
Others, such as Neilinger at Aladdin have even seen interest for so-called CLO equity risk: the most subordinated, and therefore riskiest, tranche of a CLO capital structure.
“There is a lot of private equity interest coming in looking for these kinds of assets.Private equity understands leveraged loans, so for them buying CLOs is a natural extension, as they are the first derivative of loan portfolios,” said Basu.
(Reporting by Alex Chambers, Editing by Sitaraman Shankar)