Credit Problems Come Creeping Like A Nun

Today we are hearing that other shoes may drop on the large banks and finance companies. This time the culprits are leveraged loans and the CLOs created from them. Simply put, levraged loans are loans given to private equity firms by banks to finance leveraged buyouts. Most equity investors shriek with delight when their shares are the beneficiaries of a leveragd buyout. Typically, private equity firms take a relatively weak company private and pay up for outstanding shares. Bondholders typically loathe LBOs because outstanding bonds are subordinate to bank l0ans (some day we will discuss capital structure) and, with more debt heaped upon balance sheets, LBO companies are that much less secure. How much less secure? No one truly knows for sure because, as private companies, they are no longer to report earnings an usually do not pay ratings agencies too assign credit ratings.

During the salad days of easy money and record low defaults, investors scooped up new debt issuance or CLOs created from LBO loans. A CLO is similar do a CDO except that they are secured by leveraged loans. As with CDOs, CLOs are broken up into tranches from super senior to equity tranches. As with CDOs, CLO tranches which are AAA are rated as such, notbecuase the collateral is of high qulaity, but rather because there is much collateral and the AAA-rated tranches have a senior claim on assets and cashflows.

Which banks are exposed to CLOs? The same ones exposed to CDOs. Expect billions more in writedowns, though not as much as with subprime CDOs. The pain is not over for financial institutions. There is still likely to be fallout from a weakening cmomemrcial mortgage sector. If the economy slows, it is unlikely that the commercial mortgage sector will escape unscathed.


One has to wonder what money markets, pension funds, municipal investment pools and professional money managers are still loaded with this garbage and are unwilling or unable to unload it due to poor bid prices or lack of buyers.

That is the bad news. The good news is that it is unlikely that any of the big banks will default (though one namless big bank is doing its best to cause angst among investors and employees). Oversight and controls were very lax. It is likely that they will become much more careful managing risk.

Todays announcment by insurance firm AIG that its accounting accurate has many on Wall Street fearing more skeletons in closets of Wall Street. We would be willing to bet that more pain, mergers and restructuring is coming to banks, brokers and insurers. In spite of all this, credit spreads make bonds issued by larger firms compelling, if one is willing to ride out the volatility. I would choose large troubled banks over homebuilders for a speculative play. Homebuilders will continue to tred lower. I would expect more homebuilders, including another large builder, to join Technical Olympic and a myriad of smaller builders into bankruptcy.