CDO/CLO sales slowing down, LBOs becoming more difficult?

KKR, Homeowners Face Funding Drain as CDO Sales Slow (Update2)
By Neil Unmack and Kabir Chibber

July 24 (Bloomberg) -- The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said.

Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum.

``We're walking on thin ice,'' said Alexander Baskov, a fund manager who helps oversee $25 billion of high-yield debt for Pictet Asset Management SA in Geneva. ``People are trying to find value and the right price and right now nobody knows what it is. Pretty much everyone is in the dark.''

Investors are demanding yields 15 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 5.5 percentage points in February, according to data compiled by JPMorgan.
Deals Pulled

The shakeout is leading firms from Maxim Capital Management in New York to Paris-based Axa Investment Managers to delay or scrap planned CDO sales.

Maxim began buying mortgage bonds for a new CDO after completing its second deal in March. Chief Investment Officer Doug Jones in New York said he slowed the purchases, having acquired only a third of the assets planned, partly because the bank underwriting the deal grew concerned it could lose money as volatility increased. He declined to name the underwriter.

``We don't want to get too far along and create something that's not sellable,'' said Jones, who manages $4 billion of CDOs.

Banks are becoming more skittish about providing credit lines, called warehouse financing, managers use to buy assets that go into CDOs in the months before the securities are issued, said James Finkel, chief executive officer of Dynamic Credit Partners. The New York-based company manages $7 billion in 10 CDOs and a hedge fund.

New Warehouses
``There are just very few, if any, bankers opening new warehouses,'' said Finkel.

Axa, which manages 4.7 billion euros ($6.5 billion) of high- yield loans, abandoned plans to sell a collateralized loan obligation, a type of CDO that's mostly backed by corporate loans. High-yield, or junk, securities are rated below Baa3 by Moody's Investors Service and BBB- at S&P.

``CLOs are not that appropriate an instrument to offer investors given the current credit cycle,'' said Nathalie Savey, Axa's head of leveraged finance in Paris. ``There is so much uncertainty regarding spreads.''

The slowdown comes as private equity firms such as Kravis' Kohlberg Kravis Roberts & Co. and Blackstone Group LP, both based in New York, need to borrow at least $300 billion in coming months to finance acquisitions, according to Baring Asset Management in London.
Buyout groups rely on CDOs for 60 percent of the loans to finance U.S. acquisitions, according to JPMorgan.

More Bailouts?
``CLOs have been instrumental in funding the surge in LBOs and pushing down loan spreads,'' said Gunnar Stangl, the Frankfurt-based head of index and bond strategy at Dresdner Kleinwort, a unit of Allianz SE, Europe's biggest insurer. ``They provide constant institutional demand for leveraged loans.''

CDOs also financed growth in lending to home owners with poor credit or high debt, known as subprime mortgages. About $50 billion of home loan debt rated BBB and BBB- went into CDOs in 2006, almost the same as the total sales of mortgage backed securities with identical ratings, Citigroup Inc. analysts estimated in a report in April.

``For the last 18 months the majority of subprime ABS was bought by another securitization vehicle that issued further bonds,'' the Citigroup analysts said.

The five biggest managers of U.S. CDOs include New York-based Bear Stearns and Zurich-based Credit Suisse Group, according to S&P. Their annual fees range between 0.04 percentage points to 0.75 percentage points of the amount of underlying collateral, depending on the type of the CDO and its performance.

Merrill Leads
New York-based Merrill Lynch & Co., the world's third-largest investment bank by market value, is the biggest underwriter of CDOs, selling $55 billion last year, said a report this month by Charlotte, North Carolina-based Bank of America Corp., which cited Dealogic Holdings Plc data.

Citigroup of New York is the biggest underwriter of CLOs, managing $16.6 billion of sales, and the second-largest bank underwriter of CDOs. Bank of America Securities LLC, Wachovia Corp. of Charlotte and Goldman Sachs Group Inc. in New York are the next-biggest CDO underwriters.

On top of management fees, banks underwriting CDO sales charge underwriting fees as high as 1.75 percent, compared with an average of 0.4 percent for selling regular investment-grade bonds, according to data compiled by Bloomberg. Banks collected $8.6 billion underwriting CDOs last year, according to a report last month by JPMorgan analyst Kian Abouhossein in London. They took in another $3.8 billion from related trading, investing and other activities, the report said.

Drexel Creation
Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Sales of the securities surged to $503 billion last year from $84 billion five years ago, according to Morgan Stanley. Sales reached $251 billion in the first quarter, the Bank for International Settlements in Basel said last month.

CDOs pool assets ranging from investment-grade asset-backed debt to high-yield loans, and repackage them into bonds. The securities are split into portions with ratings as high as AAA to no ratings, known as the equity portion.

Any losses on the underlying collateral are first assigned to the equity portion of a CDO. These are mainly bought by hedge funds, banks, pension funds and managers of the CDOs, according to a JPMorgan report last week. In return for the higher risk, buyers received annual returns as high as 98 percent, according to a report this month by Morgan Stanley, citing Moody's data. The median return for CLOs was 8.55 percent, based on securities that have been liquidated, Morgan Stanley said.

Steering Clear
At the opposite end, insurers, banks and other CDOs tend to buy the less risky portions with AAA credit ratings that pay 23 basis points to 150 basis points more than benchmark interbank lending rates, according to Morgan Stanley. Governments selling AAA bonds typically pay interest at the interbank rate or less.

Buyers of the least risky portion of a CDO underwritten by Credit Suisse this month were offered annual interest 22 basis points above benchmark rates. The CDO, called Avoca CLO VIII Ltd., managed by Avoca Capital in Dublin, pooled 508 million euros of high-yield loans. About 69 percent of the deal was rated AAA. A basis point is 0.01 percentage point.

Investors are steering clear of new CDOs following the Bear Stearns debacle. Ralph Cioffi, the 22-year Bear Stearns veteran who managed the two money-losing hedge funds, tried to minimize risk by buying the top-rated portions of CDOs.

`Unprecedented Declines'
The funds were wiped out by ``unprecedented declines'' in the value of AA and AAA rated securities, Bear Stearns wrote to clients last week. The losses triggered a selloff across credit markets because of concerns that a fire sale of CDOs would mean losses for holders of even the least risky debt and that fewer sales of new CDOs would reduce demand for bonds and loans.

``If the experts are getting it wrong that says something,'' said Kevin Lyne-Smith, who helps oversee $100 billion as managing director at Julius Baer Holding AG's private banking division in Zurich.

Even with the widening in CDO spreads, the funding cost remains at around the average over the past five years for deals backed by leveraged loans. Defaults by speculative-grade companies slid to a 25-year low of 1.12 percent worldwide in June, Standard & Poor's said.
Weathering Disruptions
CDOs were booming until the Bear Stearns funds collapsed. New funded deals are up 31 percent this year to $315 billion, according to JPMorgan.

Sales of U.S. funded CDOs, which include only CDOs sold to investors as bonds, were $6.1 billion in the U.S. this month, down from $36.7 billion for all of June, according to JPMorgan.

Deals are still being completed. London-based Elgin Capital, a fund manager co-founded by Michael Clancy, who formerly helped run Merrill Lynch's credit trading operation, sold 400 million euros of CLOs in July. BNP Paribas SA, based in Paris, underwrote the sale, offering yields for the BB-rated portion at 425 basis points over interbank rates, less than the spread of 480 basis points on similarly rated securities it sold in May 2006.

The CDO market has weathered disruptions in the past. In 2002, bond defaults by telecommunications companies including WorldCom Inc., now Ashburn, Virginia-based MCI Inc., caused junk- bond CDO sales to drop by 19 percent from the previous year as rating companies downgraded the securities. In 2003, CDO sales increased 18 percent to $99 billion, according to Morgan Stanley data.
Better Terms

M&G Plc, the fund-management arm of London-based insurer Prudential Plc, is considering a new CLO fund when the market stabilizes.

``We don't know when it will come back, but it should,'' said Dagmar Kent Kershaw, who helps manage 6.5 billion euros of CDOs at M&G. ``We believe now is a good time to get into the market, as some of these assets are cheaper than they have been for a while and offer excess value to the savvy investor.''

Frankfurt-based Deutsche Bank AG is leading banks attempting to sell 9 billion pounds ($18.5 billion) of loans to finance KKR's 11.1 billion-pound takeover of U.K. pharmacy chain Alliance Boots Plc with billionaire Stefano Pessina. KKR partner Dominic Murphy in London declined to comment.

``Before, you could structure an aggressive loan, and knew that a CLO would buy it,'' says Miguel Ramos Fuentenebro, managing partner at Washington Square Investment Management in London. ``Now you can't be so sure.''

Cerberus Capital Management LP, based in New York, increased the interest margins on $12 billion of loans to finance its buyout of Chrysler in Auburn Hills, Michigan, to 300 basis points over Libor for five years on the biggest portion of the debt, up from the 275 basis points it initially proposed.

``It's dangerous to call the end of a market, but there are concerns,'' said Jeroen Van den Broek, credit strategist at ING Groep NV in Amsterdam. ``Private equity firms are going to have to pay up. The cost of debt is significantly higher than it was two years ago.''