David Stockman was Director of the Office of Management and Budget under President Ronald Reagan, serving from 1981 until August 1985.
– Here They Go Again: Wall Street Is Offering Debt-On-Debt-On-Debt! (David Stockman’s Contra Corner, May 6, 2014):
Here’s how the daisy chain of debt works— short form. LBO’s issue debt—loads of it. Leveraged buyouts are now being priced at typical top-of-the-bubble ratios of 10X cash flow (“adjusted EBITDA”). The portion of these LBO debt towers that consists of bank term loans and revolver facilities is sold to freshly minted financial conduits called CLOs (for Collateralized Loan Obligations) which are not real companies and which do not have any money!
No problem. What happens is that credit hedge funds and Wall Street trading desk hit a computer key, open a new spreadsheet window, wrap it in legal boilerplate, provide this newly minted CLO with a credit line and then start bidding for available LBO paper in the junk loan market. When they have accumulated enough offers, they slice and dice the resulting portfolio of LBO loans, and issue multiple tiers of debt– with these new slices being rated from AAA to junk against the loans listed on the spreadsheet.
So we now have a spreadsheet, a part-time “portfolio manager” and hundreds of millions of the latest CLO toxic waste. For 95 weeks running, there was no want of buyers for this CLO issued paper. In its infinite wisdom, the Fed drove interest rates on CDs and high quality paper to nearly zero—–so the scramble for “yield” was on. Soon Grandpa was being forced to buy a high yield mutual fund in order to pay the light bills.
But now LBO risks are soaring due to recklessly escalating deal prices and also because the LBO kings are stepping-up their patented late cycle cash strip-mining operations in the form of “leveraged recaps” funded with new “cov lite” debt. So even yield starved retail investors have begun to turn tail and run. During the last two weeks there were actually outflows from high yield mutual funds.
That leaves a big gap in the market, however. The CLO jockeys are still banging out new spreadsheets, but buyers for the sliced and diced CLO paper are suddenly getting scarcer. Still, no problem!
Here’s why. Wall Street is back in the business of lending money at the Fed’s gifted rate of zero plus a modest 80 basis point spread—so that the fast money can buy CLO paper on 9 to 1 leverage. There is your triple shuffle.
It didn’t work out last time, but that doesn’t matter because the game is obvious. After enough buying on Wall Street’s triple leverage, junk loan prices might temporarily rebound. Then the brokers will put out the call to retail: The junk loan asset class is rebounding—its time to come back. For the final shearing, that is!
Today’s Wall Street Journal article explains exactly how its being done. Needlessly to say, every one of the big banks back in the business got bailed out last time by TARP and the Fed. They seem to learn something—even if our policy makers never do…
By Katy Burne, Wall Street Journal
Banks again are doling out money to hedge funds and other investors to finance purchases of complex debt securities, returning to a practice that helped fuel the debt boom ahead of the financial crisis.
RBC Capital Markets, Société Générale ., BNP Paribas and Wells Fargo are among the banks offering to let investors borrow money, also known as providing leverage, to buy collateralized loan obligations, say investors and bankers. CLOs are bonds typically backed by pools of low-rated corporate loans.
Borrowing programs for such esoteric securities have been only selectively available in the years since the crisis. While banks have lent to a handful of investors, the practice picked up late last year when funding costs began to fall….
Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.
Banks “are resorting to creating economic incentives to get primarily hedge funds to step into this void,” said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs….
Hedge funds “have finally come to grips with leverage and begun to embrace it” for CLOs, said Jean de Lavalette, head of securitized products sales at Société Générale.
But with leverage comes risk. Even a small drop in the market could force investors to pledge more cash and other collateral to offset the securities’ decline. Losses are magnified when borrowed money is used….
…..GoldenTree Asset Management recently purchased CLOs using leverage. Joe Naggar, a partner at GoldenTree in New York, said using leverage makes sense because prices on highly rated CLOs have fallen, increasing their yield relative to other debt securities. Borrowing money to buy could bolster returns if prices rebound…..
Banks have offered to lend some investors as much as $9 for every dollar that the buyers invest in CLOs, say traders and strategists. Others are being offered $8 for every $2.
An investor in a triple-A-rated CLO earning 1.50 percentage point over the London interbank offered rate—using 10% of his or her own money and paying 0.80 percentage point over Libor for the financing—could earn about 8% in a year. That compares with annual interest rates near 2% on a standard triple-A CLO.
Citigroup researchers in a mid-April note to clients predicted that the new source of financing could help drive up prices of triple-A-rated CLOs.
That could be a boon to a market that has stumbled under the threat of new rules on what banks can hold on their books. CLO prices tumbled, and the creation of new CLOs slowed earlier this year as the market digested the rules that will ban banks from investing in certain CLOs.
Since then, CLO prices have begun to recover, and CLO issuance has picked up after a slow start to the year. More than $35 billion of CLOs were created so far in 2014, the most for that period since 2007, when $36.4 billion were created, according to S&P Capital IQ Leveraged Commentary & Data….