More Signs of Credit Market Stress

A front-page Wall Street Journal story picks up on an alarm sounded over the weekend by the Financial Times, namely, that the leveraged loan market (the paper used to fund LBO deals) is in serious trouble. Investment banks are sitting on sizable unsold inventories that are declining in value, thus sure to lead to further writedowns. And ironically, the Fed’s interest rate cuts are only making matters worse. These instruments are floating-rate, priced off the short end of the yield curve, so rate cuts lower their interest payments, making them less attractive to investors.

The Journal article adds some useful information: UBS and Wachovia are set to auction $700 million of loans believed to underlie some collateralized loan obligations (instruments made from pools of leveraged loans) adding to further pressure to the market. And other credit markets are seizing up as well. The FT reports that the CDO market has ground to a near-halt. The Financial Stability Forum, an advisory group to the G7, gave a cheery report last week:

Since last autumn, we have seen some easing of conditions in money markets but growing worries about the impact of asset price declines and anticipated credit impairment on financial institutions’ capital and lending capacity. As institutions adjust to these conditions, the potential exists that risk shedding could tighten credit constraints on a widening set of borrowers and thereby slow economic growth, which could further impair credit. Uncertainty about how much these forces will affect growth in turn affects asset pricing and earnings prospects at financial institutions. There remains a risk that further shocks may lead to a recurrence of the acute liquidity pressures experienced last year. It is likely that we face a prolonged adjustment, which could be difficult.

Highlights from the Journal story:

In the past few days, low-rated corporate loans — the kind that fueled the buyout boom of recent years — have plummeted in value….

One sign of investors’ anxiety: Standard & Poor’s said its index of the prices on high-risk corporate loans fell to a record low of 86.28 cents on the dollar at the end of last week…

Many types of investors have left the market for such loans, including individuals. According to AMG Data Services, investors pulled their money out of bank-loan mutual funds for the 18th straight week as of last Wednesday, an exodus that has withdrawn $4.26 billion from the market.

This, in turn, has created problems for securities called collateralized loan obligations, which are pools of bank loans bundled together and sold to investors in pieces…

This week, UBS Securities and Wachovia Securities will be trying to sell portfolios of loans that may be held by a class of collateralized loan obligations called market-value CLOs. Both investment firms were lenders to these CLOs, which depend heavily on borrowed money. Now, with the market value of the loans behind these securities falling, the firms are liquidating a total face value of more than $700 million of them.

Fitch Ratings last week cut the credit rating on pieces of 24 CLOs, putting several of them deeply into junk territory, with ratings in the triple-C or double-C range. Fitch also says it is reviewing its methodologies for rating market-value CLOs. These investments have triggers in place that force banks to liquidate loans being used as collateral when their prices fall by a certain amount.

Having to liquidate portfolios of collateral is an added burden for banks, which already had $152 billion of loans they were trying to sell from buyouts of recent years. As the values of the loans they are holding decline, they could need to take additional write-offs. Market-value CLOs account for about 10% of the estimated $300 billion market for CLOs, according to research by J.P. Morgan Chase & Co.

Related investments called total return swaps have also been hurt. These instruments are set up by banks for hedge-fund clients or other investors to buy loans with borrowed money. The loans serve as collateral, and when the values of the loans decline, the banks’ clients can be driven into forced sales.

Citigroup Inc. is one of several banks affected by the upheaval. The bank structured nine of the 24 CLOs Fitch downgraded, amounting to about $4.5 billion of loans, according to a person familiar with the matter. Citigroup issued a statement Thursday saying the bank hasn’t liquidated any loan collateral associated with its total return swap program.

Problems are cropping up elsewhere in credit markets. Money-market investors in the past have been large buyers of short-term instruments backed by tax-free municipal bonds and student loans. But they have been shunning these instruments — known by such names as auction-rate securities and tender-option bonds — because they fear the debt used to back the instruments will default or get downgraded by rating services.

Thursday and Friday, Goldman Sachs Group Inc. held auctions of hundreds of millions of dollars in securities backed by student loans, all of which failed to drum up enough demand at their asking prices….

Several sales of auction-rate securities have failed to draw sufficient interest from investors in the past two weeks. These include auctions held by Georgetown University and Sierra Pacific Resources Inc. The failures leave investors paying a premium to lenders who would rather let go of the debt.