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Monday, 12 September 2011

Credit Markets @ Workout Inflexion Point

During the private equity leveraged-buyout boom and the housing bubbles in the US and other developed countries, and up to the height of the financial crisis, demand for leveraged- and mortgage  loans came mostly from structured finance offerings such as collateralized debt obligations (CDOs) and mortgage backed securities (MBS). Since the 2007 sub-prime driven unravelling of structured credit portfolios, with inherent flawed model assumptions, the subsequent clearing of debt markets has been incessantly underway. The ‘workout’ in identifying fair-value of these hard-to-value assets, which had been battered in the ensuing ratings downgrade and plummet in mark-to-market valuations, is showing dividends. 

As a turning point and until the sovereign debt turbulence of August 2011, there are both obscure and vivid examples of the clearing of credit market. Adjectives for loans, credit and debt have become prominent in recent financial vocabulary, with descriptions such as “delinquent”, “non-performing”, “in forbearance”, “distressed”, “credit quality” etcetera. The premise for FPM’s inflexion in credit assertion is based on interest rate and credit cycle and plethora of credit-related market activity.

Micro Workout Amid Macro Stability

The micro-economic aspects of asset bubble economies of 1998-2007 are and were being fixed amid macro-economic monetarist stimulus, introduced by the then chairman of the Federal Reserve, Alan Greenspan. Asset bubbles bursting, whether related to emerging markets-, technology / TMT, or sub-prime housing, inevitably leads to recession and recovery periods.  Recent stimulus included the massive re-capitalisation of banks to preserve their regulatory capital requirements from the effects of withering asset quality valuations in structured securities (and ‘ballooning’ notional CDS exposures – look out for “CDO vs CDS”, an FPM note to follow). The new paradigm of easy credit from central banks’ “pump and prime” such as low interest rates and government tax relief prevented asset bubble recessions spiralling into protracted deep ones while solvency issues were sorted at the micro level.

FPM has collated some evidences of active loan markets including the purchase, unbundling and selling of pooled loans, and higher recovery values. Also indicative of restoring economic order and confidence are the multiple legal cases surrounding mortgage securities mis-selling etcetera. Litigation and settlements may not seem a credit quality issue other than its confidence-restoration link to the structured securitization debacle. FPM’s insight suggests these litigation and resultant outcomes affect investors holding these mortgage debt or leveraged loan secuirities, at least their recovery values in situations of loss-making positions. Mortgage litigation losses remain a dark cloud looming over financial services. As is the impact of forebearance. The Bank of England warned in its semi-annual Financial Stability Report this year that it may explain the lower rates of arrears and repossession for homeowners in this recession than in the last (See FT article: Iceberg of soured loans hides true losses).

Mortgage Loss Litigation 

After the fire-fighting period post-Lehman 2008, the SEC started initial investigations into the mortgage-bond selling by suing Goldman Sachs in April 2010 over the Abacus 2007-AC1 deal. Then broad-based investigations and subpoenas ensued in the autumn / fall of 2010. The results of law suites, litigation and settlements are now unfolding in the 2H11; as are independent fresh cases such as the July 2011 lawsuit filed by China Development Industrial Bank. CDIB claims that Morgan Stanley "misrepresented the risks" of CDO called Stack 2006-1 Ltd.

Some of litigation workout examples augur mixed fortunes for indicted banks. In June 2011, it was reported that JPMorgan Chase agreed to pay $153.6 million to resolve US SEC charges that it misled investors in a mortgage-related CDO, named Squared CDO 2007-1, it constructed for Magnetar, an Illinois hedge fund. Similar settlement later that same month when Bank of America completed an agreement to pay $8.5 billion to settle claims related to subprime-mortgages securitization (via mortgaged backed securities). This last settlement represents one of the single biggest, related to 20 institutional investors including fund management behemoths BlackRock and Pimco. Clearly such steps, ‘clears the slate clean’ of the malfeasance in securitization and ensuing financial crisis. As caveat, this author’s optimism is tempered by headline risk of such reported settlements.
Stop Press: FPM told you so! As of 2nd of September 2011, Federal Housing Finance Agency of the US is suing 17 banks for losses related to mortgage security mis-selling. Adding to the current on-going market jitters, the 17 listed global banks including securitised mortgage players such as GE and Countrywide Financial and First Horizon National, had their stock prices marked down between 2 and 8 percent on the news. These traded lower due to additional liability to banks’ capital stemming from the potential new litigation losses (up to $20 billion mentioned) related to the selling of some $120 billion of RMBS.

FPM long-memory research reminds us that banks churned out $1 trillion plus of CDOs and the like. These structured ABS with multiple ‘tranches’ led to some $2 trillion of writedowns and credit losses for global financial firms since the start of 2007.
Also, since 2000 the leveraged loan market grew significantly, and at the end of 2007, the market for leveraged loans was worth $1,061 billion, making it the largest corporate debt market.

As for the biggest asset-play market, US mortgages not held by Government Sponsored Entities (GSEs) but in private mortgage conduits accounted for nearly $3,000 billion at the end of 2007. These non-agency MBS in the US accounted for $1,800 billion at the end of 1Q2011, according to the Federal Reserve. Remember the total mortgage debt outstanding held by major financial institutions, Federal and related agencies and mortgage pools or trusts is $13,700 billion at end-March 2011 (similar in size to the entire US GDP).    

CLOs Transform into Mutual Fund Offerings

The institutionally-held investments in securitised debt, rashly generalised as ‘toxic assets’, are being repackaged into simpler mutual fund structures (both closed-end and open-ended varieties). These portfolios’ constituents are primarily private-equity leveraged loans and/or securitized home equity loans with short- to medium-term refinancing instruments.
Indicative of credit workout, noticeable that in March 2011 Apollo Global Management, a top 5 global private equity firm providing loan-financing; and a large exchange-traded fund (ETF) manager Invesco PowerShares, both launched portfolios where the underlying is ‘legacy’ loan paper.

Apollo’s closed-end fund (CEF), a long-only mutual fund with limited issuance of shares and traded on exchanges, constitutes floating rate notes or FRNs.
FPM’s new-trend-notice reflects that FRNs have become “attractive option for refinancing loans”, as confirmed by Paul Hatfield on Creditflux.com. The pre-financial crisis model of borrowing short-term through asset-backed commercial paper (ABCP) market, and lending / investing in longer-term higher yielding assets (such as CDOs andCLOs), is a model that broke down during the financial crisis, by its functional seizure.

Invesco Powershares’s offering became the first ETF for corporate bank loans. The ETF tracks the S&P/LSTA US Leveraged Loan 100 Index, a basket of the 100 largest and most liquidly traded loans.
Investors have allocated cash into mutual funds that buy such loans, increasing the assets managed to $37bn as at February 2011, according to Lipper the fund tracker.

AXA Investment Managers in Paris, with a division specialised in structured credit, were one of the early users of the CEF structure for ABS investments via its Volta Finance (ticker: VTA). Which invests in corporate credits, CDOs, ABS, leveraged loans, and infrastructure assets. Since the launch in October 2006 pre-crisis and the systemic crash in 2008 there is an up-trending price recovery (See Chart 1). Another Amsterdam listed CEF, Tetragon Financial Group (ticker: TFG), launched in 2007 also experienced similar price slump in the 2008 but has bounced back stronger (see Chart 2). Further primary fund analysis is required to understand the performance difference, whether due to better underlying loan picking or refinancing etcetera.    

  
Another notable structured products CEF vehicles is the Carador fund (ticker: CIF) managed by GSO Capital which is owned by the Blackstone Group.

FPM believe this repackaging of underlying credit is better suited to CEFs as opposed to open-end vehicles or the defunct and complex CDO model. With mutual funds the investor acquires only stock / equity in a regulated, pre-defined product life-cycle with access to the performance of underlying commingled loans. Unlike CDO structures there is no holding of subjectively rated tranche debt paper or “waterfall payment” of interest or principal related to seniority of bond-holding and correlation of loan defaults etcetera. All investors in mutual funds have equal economic interest as equity shareholders with income and capital growth expectations, ceteris paribus.

Distinguishing between open-end and closed-end mutual fund structures investors are advised to consider CEFs as long-term investments. A secondary market in CEF fund sales-trading ensures possibility of liquidity. Where the bid-offer price for the underlying CDOs, inclusive of securities transaction cost, is perhaps referenced to a proxy benchmark, say Markit CDX North America Investment-Grade Index. Already analysts have expressed some concern at illiquidity in the underlying loan market.

Structured-Debt Hedge Funds

According to HFRI hedge fund indices and FPM analysis the top-performing investment strategy is the Relative Value Fixed Income Asset Backed.  This strategy’s benchmark produced 39.8% compound over 4 years ending June 2011 (or 8.7% annualised). FPM research recommend performance and diversification strengths of eight hedge fund managers with expertise in fixed income and particularly securitised ABS, either in mortgages and/or leverage loans (as listed below). For example, the mortgage funds’ securitised debt strategies may specialise in pre-payment sensitive mortgage-backed securities, which show little correlation to other markets. Leverage loan plays include Par structure CLOs.

Aladdin Capital
The Aladdin Opportunity Fund was launched in mid-2008 with the goal of profiting from knock-down value across asset-backed securities (ABS) markets.
Cairn Capital
European ABS and leveraged loan specialist launched its Cairn Capital Structured Credit Fund “to capitalize on current dislocations and opportunities across the spectrum of structured credit”
Cambridge Place Investment
Cambridge Place specialises in asset-backed debt and related instruments, including private investments and real estate.
Chenavari Financial Group
Toro Capital 1 has produced gains of 27.8% over the first six months of 2011 and 338.7% since inception in June 2009, and managed by 36 years old Frederic Couderc.
CQS (UK)
The CQS ABS fund has returned an annualised 35 percent since launch in October 2006 to date end-June 2011.
GSO Capital
The credit trading arm of Blackstone Group launched GSO Capital Opportunities Fund in 2008, and gained 13.5% net internal rate of return. They have launched a second fund in June 2011.
Structured Portfolio Management (SPM)
SPM's mortgage backed arbitrage fund Structured Service Holdings claimed top spot for 2010 in Bloomberg’s Top 100 Hedge Funds with gains of +49.5% (following the fund's 2009 returns of +134.6%)
Tetragon Financial Management (formerly Polygon Credit Management LP)
Senior secured bank loans (aka leveraged loans) constitute the main assets of Tetragon Financial Group.  TFG gains exposure to these assets through existing and new investments in the residual tranches of CLO and CDO products.
Table1: Source: FPM

Plethora of Credit-related Market Activity (See also Addendum below)

The unbundling of securitized debt and subsequent realization of value is the credit market propping mechanism or trend that FPM are highlighting in this note. Repackaging debt is in itself is not a new financial solution: remember the Brady bonds of the late 90s, where an emerging markets bubble and subsequent debt overhang from bank issuers, were resolved by the debt being wrapped with IMF guarantees and sold into the market.

The equity tranche or first loss tranche of structured ABS is even in some leveraged loan structured products showing value. The above mentioned Volta Finance fund managed by Axa Investments reported in June that its CLO residual holdings or CLO equity positions were being marked at 75% of par on average. CFlux’s secondary CLO index levels of Dollar denominated equity tranche shows 46 cents on the dollar as at end August 2011. This suggests an entry point in such plays. Arbitrage across the spectrum of structured credit certainly exists. CLO management agreement transfers is an active market due to nuances of terms contained in the structures and discounted prices of these assets with inherent time-value if not as yet intrinsic value. (Await forthcoming structured product “CDO vs CDS” FPM research).

Citi Capital Advisors, a unit of Citigroup, led firms taking over the management agreements of $4.5 billion of CLOs in the US in August alone. There are also plenty evidences of fund raising to get in on the action. CQS, a hedge fund mentioned above, announced in June that it is capping the CQS ABS fund, launched in 2006, after it has raised $2 billion. The fund then managed $1.6 billion. Other fund-raising efforts announced at similar times this year are by GSO Capital, planning to raise up to $3 billion, and Avenue Capital aiming to gather as much as $2 billion to focus on investing in the debt of US companies. Remember this secular trend started in early 2010 of the credit cycle, where Fortress Investment Group bought two businesses with a total of $13 billion in CDO assets. Carlyle Group acquired the collateral management contracts for 11 CLO funds managed by Stanfield Capital Partners. Carlyle also took a 55% stake in a long-short credit hedge fund Claren Road Asset Management.

Also indicative of credit comeback is the Rothschild Asset Management take over of credit manager Elgin Capital. Elgin’s other credit funds had closed during the credit crisis, with the remaining business being the management of four CLOs. Consolidation in the structured products by larger well-backed institutions capitalizes on fund-raising difficulties weaker rivals face. This trend is natural and expected in the credit cycle and FPM has highlighted its significance for investors.

An obscure but relevant statistics about the state of credit markets is the level of balance sheet write-downs or write-ups of credit assets. FPM noticed that US banks’ revenues from credit trading were lower in 1Q11 on quarter-to-quarter basis with 2010. Office of the Comptroller of the Currency reported in its 1Q11 Quarterly Report on Bank Trading and Derivatives Activities:

“…The relative absence of these write-ups in 2011, compared to both 2009 and 2010, explains the difference in trading revenues in these periods.”
   
FPM interpret this “relative absence of write-ups” on legacy credit assets as signal that fair-value in mark-to-market is now accomplished, and further that credit issuance and trading is set for revival. Less credit business explained the overall lower bank trading revenues, therefore means of growing credit revenues will be an imperative for banks.
However, FPM author feels that this may come from higher interest rate environment, but that not being a credible policy option now; other credit flows will need to be substituted. Possibly, increasing syndication and trading in sovereign debt, as witnessed in August and into September this year.  

FPM’s Contrarian Credit View

The corporate credit-boom, credit-crunch and subsequent workout in the financial services sector have been cyclically profitable – with entry points provided by uncertainty in economic fundamentals, such as current concerns about policy makers’ ability to deal with sovereign deficits and debts. A case-by-case analysis is certainly warranted rather than the broad-brush treatment. As this if to highlight this concern, Bank of America through its acquisition of Merrill Lynch and Countrywide Finance still faces a situation of dealing with $1 trillion of problem home mortgages.

The final positive note is that the credit comeback started in mid-2010. Singling out the largest corporate debt markets as an example – see Chart 3 below, FPM feel confident in confirming Credit Markets @Optimistic Workout Inflexion Point, despite August sovereign debt news-flow. This assertion is time-stamped using US Market screen-shot from Google finance page on 9th September, 2011: alternative for FPM to being a contrarian cash investor (Chart 4). 
Chart 3

 
Chart 4


Addendum 
Lloyd Bank (UK) is accelerating its sale of bad commercial property loans. In 2010 it sold about £4 bn of real estate loans through "forcing an administration or encouraging and investor exit". In May Lloyds  marketed its first sale of a portfolio of distressed property assets, making £1.8 bn in 1H11 propety disposals.
The Bank still has about £23.7 bn of troubled real estate loans, while Savills estimate about £350 bn of outstanding debt in the UK commercial property market. The sale is expected to managed by  JPMorgan Cazenove and is currently in early stages.

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