The Corporate Loan Conundrum

Here's our two cents worth on the year-end state of the leveraged loan market, and a little insight into the challenges that lie ahead.

First off, 2008 was a tough year for corporate loans. Among leveraged loans, we saw roughly 4.5% to 5% defaults for the year, heavy pricing declines (the S&P/LSTA U.S. Leveraged Loan 100 Index was down roughly 30% in '08) and with them low recoveries, due, among other things, to the supply/demand problem and pessimistic perceptions for the economy.

(Worth pointing out was a slight uptick in the second half of December. Was this a bottoming out? A false bottom perhaps? Some high-level executives and managers are vocal about current spread levels being at or near their highs, and that we're due for some tightening in 2009. See for example Creditflux's Viewpoint: Looking for the bottom; but are they talking their book, and do we really have a good feeling for the duration of loans in this low, slow prepayment environment?)

An Issue of SUPPLY (and demand)

Demand is so small is deserves only a side mention; supply is the elephant. Why?

1. Fund (incl. hedge fund) liquidations and forced selling, to meet both investor redemption requests and (particularly variation) margin calls
2. Selling by banks to decrease leverage
3. Overhang of unsold loans (incl. bridge loans) on syndication desks' balance sheets that the banks were no longer able to securitize due to the severely diminished CLO juggernaut, a previously major source of demand for broadly syndicated loans
4. Demand by existing CLO managers has decreased too:

• low prepayments on current loans in the portfolio mean less available principal to reinvest
• loan downgrades have resulted in many CLOs maxing out on their CCC-rated buckets (which in turn limits managerial flexibility in trading new loans)
• historically low loan prices mean that investments in these loans are reflected as "deep discount" purchases for overcollateralization test purposes

What the future holds for loans and CLOs

Corporate loans weren't highly traded, relative to bonds, say, prior to the onslaught of CLOs (which steadily gained steam from 2001 to early 2007). S&P/Markit/Reuters' move towards a CUSIP identifier (from LoanX, LN numbers) may prove of minor assistance to the liquidity situation, but this will take a while.

The prospects are dim for 2009: large supply and high defaults are typically accompanied by low recoveries, a dual burden (see for example Longstaff, Schwarz's "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt").

As this relates to CLOs: as defaults continue to plague corporations and deals continue to fill their CCC buckets -- and then have excess CCC assets haircut at market value (not recovery rate) for overcollateralization test purposes -- more CLOs naturally begin to trip overcollateralization triggers on a weekly basis, causing cashflows to be directed from the junior tranches and residual pieces towards paying down senior note holders (reducing the duration of the latter).

Similarly detrimental is the fact that most CLOs ramped up their loan portfolios during a credit cycle marked by the particularly high levels of liquidity it generated and the low defaults exhibited. The resulting strong demand created the opportunity for debt issuers to obtain low coupons on their debt despite weak covenant packages. Strong covenant packages typically reduce a company's cost of debt and, importantly, protect debt investors from wide negative swings in the value of their investment. (In sum, relative to a company's overall investors, weak debt covenants are arguably equity-friendly for the company, and debt-unfriendly.) See also The Luxuries of a Covenant Light Lifestyle.

The optimistic view is that this can all change quickly if we begin to see sufficient buyer power at these distressed levels. If some of the distressed funds decide that the opportunities lie in loans, and the bigger loan/asset managers (PIMCO, Babson, TCW, Blackrock) start putting their money to work, loan prices could rebound even on thin volumes and the deals which have benefitted from decent excess spread generation over the last 4 to 5 years during the low default environment may survive some of the pending difficulties. Certainly we're optimistic that many, if not most, of the AAA tranches will come out whole in this scenario, but whether the AA or single A tranches survive or suffer principal losses may differ from deal to deal, and may depend on the remaining length of each deal's reinvestment period, among other things.

While we fear the worst, we're long optimism.

Another Day, Another "Plug"

Ditto our prior article Static Measures for a Dynamic Environment:

Moody's is revising its assumptions to reflect the expected stress of the global recession and tightened credit conditions on corporate default rates, which are likely to be more variable and extreme than those in other recent historical downturns. Specifically, the changes announced today include: (1) a 30% increase in the assumed likelihood of default for all corporate credits in synthetic CDOs, and (2) an increase in the degree to which ratings are adjusted according to other credit indicators such as rating Reviews and Outlooks. Moody's also announced an increase in the default correlation it applies to corporate portfolios as generated through a combination of higher default rates and an increase in investment grade and financial sector asset correlations.

Static Measures for a Dynamic Environment

It is with a touch of disappointment that we read S&P's announcement yesterday that they're downgrading certain leveraged super senior (LSS) notes based on a change to their model.

What's particularly disappointing is that they're applying a (new) static measure for volatility -- a variable which we all know is certainly not static -- to long-term transactions. We call this a model "plug." Essentially, each time volatility changes, S&P could legitimately recalibrate its model and either upgrade or downgrade tranches (typically downgrade) on the basis of this change. From their release...

Today's rating actions reflect a recalibration of the model we use to rate these transactions. Specifically, we have increased the volatility parameter we use when simulating spread paths.

In future, we will use CDO Evaluator v4.1 and a volatility parameter of 60% to model all LSS transactions that have spread triggers. Before this recalibration we used a volatility parameter between 35% and 40%.

Given the rating agencies typically hide behind the mantra that their ratings are long-term "opinions" (expected loss or default probability measures, as the case may be) it's odd that they would adapt their model to incorporate short term "plugs." Each time volatility changes going forward, can we expect a reciprocal adjustment to be made to rating levels?

The ratings are being given based on a static volatility measure, and updated at S&P's whim to recognize the inherent flaw with the model... and that's not to mention the elephant in the room, the static correlation assumptions for all environments.

Let's look at this from another viewpoint: when trading stock options using Black-Scholes, one could legitimately argue that you're trading volatility. The price is out there in the market - it's a given. The Black-Scholes formula allows you to solve for volatility, and you could then buy or sell the option based on your assessment of the current and future volatility of the stock's price. Thus volatility is assumed to change over time, and if it were assumed to be constant (such as S&P is assuming), options wouldn't trade. Black Scholes suffers from having a static volatility measure (sigma), but if you're going to have a model where price is not known (from the market) and volatility is a huge unknown, it can't suffice to apply a static measure which then gets updated with time, at the agency's discretion, potentially adversely affecting your supposedly long-term ratings.

What do we recommend?
If rating consistency is important (which we believe it is, especially when pension funds and other endowment funds are substantial investors and when institutions place regulatory capital -- and hedge funds post margin -- against assets based on their ratings), then it's suboptimal to apply static, long-term measurements for both correlation and volatility, as these are key inputs to the model. We're not suggesting it's easy to model each variable as path-dependent, or time-dependent, but if you can't accurately estimate the key parameters in your model the only solution is to stop rating the instrument until you feel you can accurately estimate those variables.

Summary
Volatility, like correlation, is best understood as a measure that's dependent on time. Having said that, if S&P legitimately believes that the new (60%) measure is forever good, we would like to see them admit that the original measure was flawed (and show us how and why they reached the incorrect level), and reimburse all note issuers who paid and continue to pay for these flawed ratings. Ah, the responsibilities that come with collecting fees for your assumptions and modeling capabilities!