Cracking The Code (Last in a Series)

As anyone trying to get a mortgage these days knows, leverage isn’t what it used to be.

The Great Deleveraging, begun in late 2007 as the credit crunch took hold, affected the entire corporate and consumer financial services community.  Debt became a four-letter word, thanks to the unmasking of sub-prime mortgages as the true villain of the era.

Those no-income-no-equity loans took leverage to its theoretical extreme, coming to represent all that’s bad about structured credit and securitization. The carnage it brought to Main and Wall also made it impossible to appreciate all the benefits – liquidity, low cost, diversification of risk – of those off-balance sheet financings.

So when the pendulum swung all the way back, it became impossible find leverage against any assets, no matter how sound. Investors burned from trusting triple-A ratings on sub-primes, had no interest in placing bets on other investments. Even in the case of CLOs, whose best-rated tranches had never lost a dime for their holders.

But facts are stubborn things. And one fact that began to emerge from the wreck was that secured loans had performed as advertised: producing good returns with low default rates. Investors early this year, after the secondary loan market had run out of bargains, began nosing around for opportunities in structured products.

What they found was triple-A CLO debt that had held its ratings, being secured by the same assets – leverage loans – whose prices had recovered their values, running up almost to par. Except the securitization taint had kept structured liabilities priced at significant discounts to similarly rated corporate issuers.

But these prices too have slowly climbed, so that now the corresponding Libor spread reduction (from a high of 650 in April 2009 to around 240 today) has made the issuance of new triple-A debt feasible. It has also given CLO equity investors a prayer of getting more than single-digit returns.

How much leverage can that equity get today to invest in leverage loans? It’s still a developing story, but the emerging CLO model seems to require anywhere from fifty cents to a dollar of equity for each dollar of debt, or up to two times leverage. For short-term warehouse lines, the story is better, with obtainable leverage of three times.

And what sort of IRRs does that produce? If you assume a 3% liabilities cost while assets (i.e. leveraged loans) earn around 7%, that’s a 4% net spread. Add fees and, depending on your default assumptions and leverage, you can figure around a 13% return. Not bad when you consider the other investment alternatives out there.

To crack the code – get us back to where equity arbitrage makes sense for senior debt – loan buyers hope for funding costs to drop. What they fear is a similar contraction of loan spreads, which certainly seems to be happening in the land of broadly syndicated loans.

Given that middle market loans have maintained spread premiums to (and lower risks than) their large cap counterparts, it will be interesting to see if managers of new CLOs begin to see the wisdom of populating their portfolios with the debt of smaller issuers.

Randy Schwimmer is senior managing director and head of capital markets at Churchill Financial, as well as columnist for its weekly “On the Left” newsletter. Reach him at rschwimmer@churchillnet.com.