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CDOs May Bring Subprime-Like Bust for Buyouts, Junk-Rated Debt
By Caroline Salas and Darrell Hassler
March 13 (Bloomberg) -- Bond investors rattled by mounting losses in subprime U.S. mortgages say trouble is brewing in collateralized debt obligations, the same securities that fueled the boom in leveraged buyouts and cut-rate finance.
Sales of CDOs, which package loans, bonds and derivatives into new securities, rose by almost half to $918 billion last year, according to data compiled by JPMorgan Chase & Co. Demand for investments to use in CDOs has helped push risk premiums lower for everything from home loans to high-yield, high-risk bonds, forcing managers to borrow ever more money to maintain returns and stand out from the competition.
``There will ultimately be a shakeout,'' said Oliver Wriedt, a partner at New York-based GoldenTree Asset Management LP, which oversees about $8 billion and manages CDOs and was founded in 2000. ``Many'' new managers ``lack the pedigree, or at a minimum the track record. Many have not managed'' in a downturn, he said.
Managers of CDOs backed by speculative-grade loans are borrowing as much as 13 times the amount they raise in equity from investors, up from nine to 10 times as recently as late 2005, according to Wriedt. Forty-one percent of the 142 CDOs backed by corporate loans and rated by Moody's Investors Service last year were set up by first-time issuers.
Subprime Parallels
``There certainly is potential for some excesses and that could turn into some performance issues,'' said Chris Ricciardi, chief executive officer of Cohen & Co. in New York, the biggest issuer of CDOs last year. Cohen has formed 36 CDOs since 2001, including 15 worth a total of $14 billion in 2006, according to Asset-Backed Alert.
CDOs are financing a record number of loans to low-rated borrowers that forego standard investor protections, such as quarterly limits on the amount of debt relative to earnings. Some $36 billion of the loans were made this year, more than the previous 10 years combined, New York-based Morgan Stanley found.
Individuals with poor credit histories who borrowed for home loans obtained similar easy terms. Many of those subprime loans also have ended up in CDOs.
As of Dec. 31, about 10 percent of subprime loans in securities were either delinquent by at least 90 days, in foreclosure or turned into seized property, the most in at least seven years, according to securities firm Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia.
`Toxic Waste'
``When you talk about no documentation loans, you can't have any less of a standard than that,'' said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. The lenders ``lower their standards and say `Well, we can put them into CDOs.' Like that's somehow burying that it's toxic waste.''
About $173 billion of CDOs backed mainly by U.S. subprime mortgage bonds and related derivatives were created last year, according to New York-based JPMorgan. Yield premiums for BBB rated bonds issued by CDOs that hold some of the riskiest mortgage debt have soared to 6 percentage points over benchmark rates from 3.65 percentage points this year, JPMorgan found.
Investors ``need to worry a good bit'' about subprime delinquencies spilling over into the CDO market, said Mark Adelson, head of structured finance research at Nomura Securities Inc. in New York. ``The scenario where the BBBs all blow up is a reasonably possible scenario,'' Adelson said.
CDOs backed by asset-backed securities have already lost about $20 billion in value as delinquencies have increased, according to Lehman Brothers Holdings Inc. data.
Drexel Invention
CDOs were first set up in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk bond king Michael Milken. Junk, or high-yield, debt are rated below Baa3 by Moody's and BBB- by Standard & Poor's.
Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating, and are known as the equity tranches because they are first in line for any losses. Investors in the equity portion expect to generate returns of more than 10 percent.
Fees for managers can range from 45 basis points to 75 basis points of the amount of the CDO, GoldenTree's Wriedt said. For a $500 million CDO, a manager earning a fee of 50 basis points, or half a percentage point, would pocket $2.5 million a year until maturity.
Besides Cohen, the other top five issuers of CDOs last year in the U.S. were Trust Company of the West in Los Angeles, New York-based Goldman Sachs Group Inc., Duke Funding Management LLC in Greenwich, Connecticut, and Aladdin Capital Management LLC of Stamford, Connecticut, according to Merrill Lynch & Co. in New York.
Better than GE
CDOs with loans and AAA ratings yield 23 basis points over benchmark rates, according to JPMorgan. That's 10 basis points more than top-rated regular corporate bonds sold by Fairfield, Connecticut-based General Electric Co., Merrill Lynch data show.
The Dallas Police and Fire Pension Fund invested in its first CDO about two years ago to boost returns, according to Richard Tettament, administrator of the $3.2 billion fund.
``We were beefing up our risk and we were hoping for a greater return,'' Tettament said in an interview from his Dallas office. ``We have an unfunded liability to pay off.''
Tettament said he isn't sure what type of collateral backs the CDO, though he thinks returns exceeded 20 percent last year.
Buyout firms from Kohlberg Kravis Roberts & Co. to Blackstone Group LP have been among the biggest beneficiaries of CDOs. High-yield, or leveraged, loans financed 57 percent of the record $1.55 trillion of mergers and acquisitions last year, the most in seven years, according to S&P.
`Credit Amnesia'
About $154 billion of CDOs that focus mainly on loans were created in 2006, up from $68.2 billion in 2005, according to data compiled by Morgan Stanley. The demand has allowed companies rated four or five levels below investment-grade to pay just 2.12 percentage points more than benchmark rates this month to borrow, an all-time low, S&P says.
``We think there is a kind of a credit amnesia that is going on,'' said William Chew, managing director at S&P in New York. LBO loans the last two years ``had a record number of the deals at the lower end of the credit spectrum. That's the kind of thing which tells us that these are, from a credit risk standpoint, more risky than previous rounds.''
The increase in new managers is especially dramatic in the market for CDOs backed by loans, said William May, managing director at Moody's in New York. When defaults increase, an inexperienced manager may have more trouble selling or limiting losses, he said.
``The question is whether they're going to be able to manage through a downturn if they don't have much experience,'' May said. ``That is where the trouble may come.''
Little Worry
Maxim Capital Management LLC was established last year by New York-based Maxim Group LLC to issue a $2 billion CDO of asset-backed securities, home mortgages and other CDOs, according to Fitch Ratings. The ``new CDO management team'' is cited by Fitch as a potential impediment to success.
Maxim, which plans to complete another $2 billion CDO by the end of this month, is more committed to managing CDOs than large firms because management fees are its main source of revenue, said Chief Operating Officer Armand Pastine.
``It's the emerging manager that is fully committed to this business and that is not running away from it,'' Pastine said.
Investors in CDOs have had little to worry about. February was the first time in more than nine years that no speculative- grade companies defaulted, Moody's said last week.
Competition among CDO managers is so fierce that GoldenTree took 11 months to find enough attractive loans for a $750 million fund created two weeks ago, about double the amount of time it took to collect collateral in 2002, Wriedt said.
``In today's market there is very, very little margin for error unless you have great conviction in the quality of your loan portfolio,'' he said.
UNC Stays Away
The University of North Carolina at Chapel Hill, which invested in one CDO backed by loans in 2002, isn't buying any now, said Mel Williams, vice president and co-founder of UNC Management Co., which oversees $2 billion of endowment funds for the school.
``We have historically only invested in the equity tranche and today those equity tranches are yielding between 10 and 13 percent,'' Williams said in an interview from his Chapel Hill office. ``Given the level of risk we feel we're taking in those pieces of paper we don't feel we're being compensated.''
BlackRock Inc., the second-largest publicly traded money manager in the U.S., is marketing a synthetic CDO called Galena CDO II. The New York-based firm promises investors it won't succumb to the temptation of buying worsening credits because they offer higher yields than similarly rated securities.
In a prospectus for the CDO obtained by Bloomberg News, the firm said it will use a ``disciplined credit approach to avoid `easy' names with high spreads pending downgrades such as LBO candidates'' like Chicago-based Tribune Co., the newspaper publisher considering a breakup or sale, and San Antonio-based radio operator Clear Channel Communications Inc., which is lobbying for a $19 billion buyout.
Brian Beades, spokesman for BlackRock, declined to comment.
To contact the reporter on this story: Caroline Salas in New York at [email protected] ; Darrell Hassler in Chicago at [email protected] .
Last Updated: March 13, 2007 00:13 EDT
