Episode Transcript:

Jim: Welcome Gene, thanks for joining us today.

Gene: Thanks Jim, happy to be here.

Jim: We’ve noticed an up tick in the credit markets in general this year and more recently in the collateralized loan obligation or CLO market too but they haven’t quite caught up with the rally in their underlying loans. Why is that?

Gene: Jim I think this is a good question and probably a good place to start.  It's good to realize first off that CLOs are not going to be necessarily 100% correlated to the price of their underlying loans, even though they are primarily secured by these leveraged loans.  The prices as we will note, it's a matter of demand and supply.  So if the market has a lack of appetite for CLOs versus the underlying loans themselves—or if there is a higher cost of funding for the CLO tranches, supposing you could get leverage on them—you’ll see the difference in price.  Secondly there are a host of risks that you’re taking on as a CLO investor that you’re not necessarily getting as a loan investor.  Model risk is an easy one because the CLO structure is perhaps more complex to model.  Liquidity risk, the potentially sizeable bid/offer spread on trading the tranche and even the potential inability to sell the tranche, that's another risk.  There are many more risks, but one timely mention is the heightened extension risk on CLO cash flows, possibly due to loan amendments.

Jim: And so if CLOs are trading at a wider spread to loans, any extension in payment will increase the differential between their prices?

Gene: Right, and these are not short‐term securities, depending what CLO tranche you’re holding, your principal cash flows can be potentially five to 12 years out.

Jim: Okay, let’s discuss the CLO market first and then we’ll come back to this loan extension theme.  This is a half a trillion dollar market and it’s had more than its fair share of bad publicity recently.  What’s your take on this? Is it a product that we’ll be seeing ten years from now?

Gene: I think it’s fair to say Jim that CLOs and securitizations as a whole have been harshly tarnished by the poor performance of certain of other asset classes, particularly those ultimately backed by residential and even commercial mortgages.  As a product CLOs seem to have outperformed and probably make more sense than structured finance CDOs or trust preferred CDOs, and so if CDOs return I would hope that or image that they will be CLOs.  I think we’ve tried to be quite vocal on our feeling here that the problem didn’t lie in the art form of securitization but the execution or, rather, implementation of securitization.  Having said that, we’re not necessarily a proponent of all forms of securitization.  CDO‐squareds for example we could probably have done without and I’m not convinced they added any material value.  But as a massive source of funding, securitization as a whole brings down the costs all the way down to the consumer level.  NERA [National Economic Research Associates, Inc.] recently produced a report to the American Securitization Forum on this.  I think that’s worth a read.  The advantages seem to be clear, but we have to manage the risks and align the incentives for this to work out.  And I’m not sure we’re ready for this.

Jim: How important are CLOs in this mix?

Gene: Looking back at this Jim, while CLOs began as early as the early 80’s it wasn’t until the turn of the Century that they really began heating up and, with them, so did the loan market.  CLOs in the 2000s were purchasers of roughly 60% of all new issue and secondary market offerings.  And that's all the way up to 2007 really.  In a way this is good.  Among other things it provides an additional source of funding, cheaper and potentially easier funding, for some of the sub‐investment‐grade companies versus say the high yield market.  But this comes with an element of systemic risk.  Because they’re a major source of supply, if CLOs suddenly stopped buying loans, demand is heavily down, which lowers prices, which weakens CLOs and so the vicious circle.  The converse is true too, to a degree.

Jim: Okay, well for CLOs in particular as a securitizable product, what’s changed from a regulatory and performance perspective? Can they survive the downs?

Gene: I think the performance or resilience of the existing deals will be crucial.  These are managed portfolios and it’s going to be in a way exciting to see how some of the better managers out there are able to get through the next two or three years of tough times ahead of us in which the quality of the loans themselves will be tested.  Will these managers be able to build par by way of well‐considered discount purchases?  And the question really is about the intrinsic quality of the loans themselves.  From a pure underwriting perspective, they’re not great but they’re also not terrible—they’re certainly not as bad as the residential loans.  We have seen a loosening of covenants from both a debt over earnings and an interest coverage perspective since 2002, also a decrease of covenants and an increase in covenant‐lite issuance, but these are tending to become much less of an issue now anyway.  Essentially lenders have been granting covenant relief rather than foreclosing on the loan.  By not exercising on this protection that's afforded to them by way of the covenants, they’re effectively allowing the covenant‐strict loans to behave as if they were covenant-free anyway.  So time will tell how well this works itself out, and how badly this may affect the ultimate recovery on defaulting loans, if and when they do default.  We put this all together, whereas three to 12 months ago the question was all about what would happen on default.  Will the company be forced into Chapter 7 liquidation without the ability to get the financing or will they be able to go into Chapter 11 restructuring?  Now we have the government pushing lending.  And the interests all around are understandably to keep a company running so as to maximize return.  And so from a negotiation perspective between the borrower and the syndicate of lenders it’s all about what flexibility is required in the credit agreement by the borrower to survive or to maintain liquidity and at what cost the borrowers may be able to keep the lenders happy.

Jim: And what is it that will keep the syndicate of lenders—the banks—“happy?”  What’s in it for them?

Gene: I think we can’t stress enough here that they don’t want defaults, they don’t want bankruptcies.  The typical rights they have, as lenders, on covenant violation—to accelerate or call the loan, to foreclose on the collateral securing the loan and/or to stop funding the unused revolver commitments—these all ultimately end up in the borrower’s bankruptcy.  So amending pre‐default is in both parties’ best interests.

Jim: And so is it that the borrowers are primarily seeking amendments to stave off immediate default?  Or are they also being proactive about managing in advance of a prolonged difficult environment?

Gene: Jim I'm glad you bring me back to this.  The answer is yes and yes. Just about every day you’re seeing a few companies either amending or seeking to amend their credit agreements.  There are two things going on here.  The first is that speculative‐grade companies are working to prevent covenant breaches, and the second is that there are speculative-grade companies seeking to extend revolving loans in advance of maturities so they can lock in financing for the medium and long term.  The first is more immediate, they want to avoid default.  The second is more about maintaining and managing liquidity and guarding against a drop in credit availability.  So to summarize we’re seeing one: the simple, and it can be temporary or permanent, covenant relaxation negotiation, and that's to stave off immediate default, and secondly, what we call the “amend to extend” amendment where it’s typically a maturity extension of the revolving credit facility that’s being requested.  And the banks will usually bargain for a higher margin or fee on both the loans and the credit facility as part of the negotiation, as well as the imposition of additional covenants, or the tightening of existing covenants.  For example the banks may seek to restrict M&A activity, they may seek to diminish dividend distribution post amendment, and the two parties may negotiate a reduction in size of the revolving credit facility and the existing term loans.  Abercrombie & Fitch’s, for example, and Wendy’s/Arby’s Group’s recent amendments are closer to the latter, the amend‐to‐extend, whereas Univision and Georgia Gulf’s amendments from early June are probably closer to the former, almost an amend‐to‐survive.  From a first glance, American Airlines’ recent amendment, we just saw this recently, their proposition to lenders, to loosen and decrease its covenants, looked to be a more of a vanilla amend‐to extend but they seem to be facing very definite short‐term financing pressure.  So the amend‐to‐survive possibility may be there too.

Jim: Alright but let’s have a look at this amendment process from a lender perspective for now and then I want to take you back to the high level and see where this is going from a capital markets future perspective.  We have a single borrower with one goal and potentially a string of banks or CLO managers who are lenders.  Does the syndicate have different incentives or needs to the CLO collateral managers or are they mostly aligned?  Or maybe a better way to ask the question is, what may make a particular CLO manager uncomfortable with an amendment that may otherwise work for the other lenders?

Gene: Jim this is a good question and it’s an important question.  I think it's important to realize that this is going to depend on each particular manager’s needs.  Each CLO as we know is going to be different and so each manager’s restrictions and flexibilities with respect to the loans in their portfolio will differ based on each manager's CLO’s indenture concentrations and so on and so forth.  One manager may have a very restrictive limitation for long‐dated securities, for example, and so may oppose an amendment that proposes to extend the maturity of the loan beyond the maturity of her specific CLO.  If we return briefly to the American Airlines example which I mentioned earlier, there’s a case where the majority of the lenders are actually institutional investors, holding what we call term B loans or term loans B.  AMR’s going to suffer as a result of this.  Already the amendment and terms that they're proposing are relatively expensive for similarly‐rated, single B companies.  Their amendment fee alone is in the region 75 basis points and that's going to cost AMR more than three million dollars.  Why?  Well for relationship reasons.  The big difference is when banks are the lenders the relationship between the borrower and the lender often goes back many, many years and may include businesses like bond underwriting and cash management and other types of solutions that the banks offer.  And so the banks are going to be even more incentivized than usual to grant covenant relief and find a solution that allows for continued revenue generation.  With institutional investors, on the other hand—and we’re talking CLOs, prime rate mutual funds and the like— they’re “transactional lenders.” In other words, their relationship doesn’t go any further back than the individual loan in question here and so their incentives will be naturally more immediately self‐serving.

Jim:  Okay Gene, let’s wrap this up with your take on how these amendments will play out for the mending or “amending” companies.  Can we reasonably expect these companies to return to profitability post amendment? What are the future ramifications for the economy as a whole?

Gene: Jim it looks like the next three to five years are going to be key, as speculative‐grade companies are going to be battling to meet their looming loan refinancing surge.  The numbers I’ve been looking at aren’t small here at all.  There's likely to be more than $500 billion in loans set to mature in 2011 and 2012 alone.  The post amendment consequences, at least from an investor’s perspective, can be quite complex if we put them all together.  On the one hand the maturity extension often leads itself to greater liquidity for the borrower, but the increased cost of funding and the reduced size of the revolving credit facility may lower profitability going forward.  I would have preferred to have ended on a more positive, optimistic note here, but the downside is that constraining future acquisition activity—and I’m referring here to the M&A restrictions or other capital expenditure restrictions—these will potentially hamper future growth across the board for these companies and that may in turn put a dampener on the speed or shape of the economic turnaround.

CapitalMarket Pulse with Jim Towne is brought to you by DerivActiv, Inc. a leading provider of web-based independent valuations for fixed-income, currency, and equity derivatives and other financial products.  Copyright CapitalMarket Pulse 2009.