Embracing Leverage Again – More Credit Insanity

The Attention Span of Mayflies

The memory and attention span of financial market participants can be compared to that of mayflies. The mayfly is a member of the order ephemeroptera, from the Greek term for ‘short-lived’ (literally: ‘lasting a day’). The English word ‘ephemeral’ comes from the same root. You get our drift.

Not long after yesterday’s post about the growing signs of unbridled speculation in credit markets was published, we came across an article in the WSJ, entitled “Borrowing Cash to Buy Complex Assets Is In Vogue Again”. We’re not particularly surprised to come across such an article, but this is definitely an interesting addendum to yesterday’s missive.

The topic are collateralized loan obligations, or CLOs for short. As the WSJ informs us, CLOs were among the structured credit products that held up comparatively well in the 2008 crisis, with not too many defaults occurring in their component loans. What’s contained in a CLO? “CLOs are bonds typically backed by pools of low-rated corporate loans”, the WSJ informs us. Many CLOs are nevertheless sporting triple A ratings, either due to overcollateralization or due to being sliced into tranches of different seniority. Banks still hold quite a few of these securities, but they want, or rather have to, get rid of at least some of these holdings:

“Many banks own CLOs themselves, holding about $130 billion on their books. New regulations may mean some banks will be forced to sell some CLOs in the next few years.

Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.

Banks “are resorting to creating economic incentives to get primarily hedge funds to step into this void,” said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs.”

What ‘economic incentives’ might these be? Banks are trying to entice hedge funds to buy CLOs by offering them credit to buy them. We learn that hedge funds have once again ‘come to embrace’ leverage. In fact, buying CLOs without employing leverage is just not worth it. But there are evidently risks…

“Using borrowed money to buy securities may help hedge funds bolster returns, a useful strategy with interest rates at rock-bottom levels on many other mainstream debt investments.

Many investors steered clear of borrowed money after getting burned in the financial crisis, when they were forced to repay loans on securities whose value had fallen. But several investors said CLO returns wouldn’t be attractive now without leverage.

Hedge funds “have finally come to grips with leverage and begun to embrace it” for CLOs, said Jean de Lavalette, head of securitized products sales at Société Générale.

But with leverage comes risk. Even a small drop in the market could force investors to pledge more cash and other collateral to offset the securities’ decline. Losses are magnified when borrowed money is used.”