February 20, 2008
Feb. 20 (Bloomberg) -- A year ago $20 million would have gotten Luminent Mortgage Capital Inc. access to $640 million in loans to buy top-rated mortgage-backed securities. Now that much cash gets the firm no more than $80 million.
“There’s nobody out there trying to lend money on securities,’’ said Luminent Chief Executive Officer Trezevant Moore. Six lenders are offering five times leverage on what the San Francisco-based company has contributed, while a year ago, 20 banks extended 33 times, he said.
Wall Street firms, reeling from $146 billion in losses on their debt holdings, are fueling a credit crisis by clamping down on lending to investors and hedge funds that use borrowed money to buy securities. By pulling back, Barclays Plc, Bank of America Corp., and Merrill Lynch & Co. are contributing to reduced demand and lower prices throughout the fixedincome world.
“The banks themselves, because they owned so much of this different kind of affected paper ranging from leveraged loans to mortgage-backed bonds, have simply got their snoot full,’’ said Roy Smith, a former Goldman Sachs Group Inc. partner who teaches finance at New York University’s Stern School of Business. They “don’t have their usual amount of room to step up.’’
Mortgage-backed bonds and high-yield, high-risk loans are trading at or near record lows as the banks’ retreat compounds the fallout from the collapse of the subprime mortgage market.
Widespread Writedowns
A surge in delinquencies on loans to homeowners in the riskiest subprime category triggered widespread writedowns on mortgage-backed securities and sapped investor demand for high- yield, or junk, loans and bonds. Banks are saddled with about $190 billion in loans they promised to underwrite for the record buyout deals announced last year, Morgan Stanley said in a report Feb. 15. Junk debt is rated below Baa3 by Moody’s Investors Service and less than BBB- by Standard & Poor’s.
Investors who borrow to boost returns aren’t the only ones feeling squeezed. On Jan. 22, Citigroup Inc., Goldman Sachs, and Deutsche Bank AG scrapped a $2 billion loan to Solutia Inc., a St. Louis-based nylon and plastics maker that was relying on the funds to emerge from bankruptcy protection. UBS AG, the second largest underwriter of auction-rate securities, notified brokers last week that it won’t buy the debt when there aren’t bidders.
The average actively traded junk loan dropped as much as 8.54 cents on the dollar this year, reaching 86.28 cents on Feb. 8, according to S&P data. Bonds rated AA and backed by prime “jumbo’’ mortgages typically traded at 72 cents in early February, down from 80 cents in mid-December, according to Bear Stearns Cos.
Junk Bonds
The extra yield investors demand to own junk bonds instead of Treasuries widened to 7.48 percentage points on Jan. 23, the most in about five years, from a record low of 2.41 percentage points in June, Merrill Lynch index data show. The spread narrowed to 7.25 percentage points yesterday.
The cost of protecting corporate bonds from default soared to a record today as investors bought insurance against losses stemming from the $2 trillion market for collateralized debt obligations. Credit-default swaps on the Markit CDX North America Investment-Grade Index of 125 companies with investment-grade ratings jumped 9 basis points to 163 at 7:44 a.m. in New York, according to Deutsche Bank.
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; adecline, the opposite.
Subprime Fallout
Collateralized loan obligations, a type of CDO that pools leveraged loans, show how the subprime fallout is spreading. Aladdin Capital Management LLC used $70 million to obtain $360 million of financing from Barclays Capital, a unit of London-based Barclays, to create a CLO in July.
Barclays this month forced the Stamford, Connecticut-based firm to unwind the CLO because the portfolio’s value had dropped more than the $29.7 million allowed in the terms of their deal, according to LaSalle Bank, the CLO’s trustee, and the fund’s prospectus. Mike Carroll, a director at Aladdin, declined to comment. Market value CLOs contain $35 billion of loans at risk of being liquidated, Victor Consoli, a credit strategist at Bear Stearns in New York, said on Feb. 7.
Liquidations Threatened
Ten CLOs have broken thresholds that may force liquidations since Jan. 18, Fitch Ratings said today, citing “unprecedented decline in loan values.’’ Hartford Investment Management Co. unwound the Hartford Leveraged Loan Fund on Feb. 8, according to Fitch. Hartford spokesman Tim Benedict didn’t immediately return a phone message.
CLOs accounted for 63 percent of loan buyers in the first half of 2007.
“Some of the most astute players with the best pedigree and goodwill with the Street cannot get a required amount of leverage,’’ said Michael Hennessey, who helps manage $10 billion in hedge funds as managing director at Morgan Creek Capital Management in Chapel Hill, North Carolina. The company’s investors include Julian Robertson, founder of Tiger Management LLC.
Declining prices are good news for investors with the funds to buy, said Brett Jefferson, a former managing director at Marathon Asset Management LLC. Jefferson is starting a hedge fund called Hildene Capital Management LLC to buy distressed collateralized debt obligations, including CLOs. He aims to raise $1 billion from investors, he said.
‘Getting Out’
“The dealers aren’t in a position to be taking on more risk, they’re in the position of getting out of risk, and it’s a great opportunity to buy,’’ said Jefferson, president and chief investment officer of Hildene in New York.
Citigroup, Goldman, and Deutsche Bank are already facing a backlash. Solutia filed suit on Feb. 6 to compel the banks to fund its loan.
“We feel the banks have pulled the rug from beneath our feet,’’ said Paul Berra, a spokesman for Solutia. Citigroup said the suit is without merit and the company has complied with all its “contractual obligations.’’ Deutsche Bank’s John Gallagher and Goldman’s Michael DuVally declined to comment.
The retreat in the $300 billion market for auction-rate securities is affecting borrowers including the Port Authority of New York, student loan provider SLM Corp. and closed-end funds run by Nuveen Investments Inc.
Rate Reduction
Banks haven’t been encouraged by the Federal Reserve’s 2.25 percentage point reduction in benchmark interest rates since September. About one-third of U.S. banks increased their standards on commercial and industrial loans, according to the Fed’s survey of senior loan officers on Feb. 4.
The ability of mortgage bond buyers such as Luminent to use leverage with their investments has diminished.
Investors in the most senior commercial-mortgage securities could typically borrow 33 times the amount of their
investment at a cost of 0.03 percentage points above the one-month London interbank offered rate in January 2007, according to a JPMorgan Chase & Co. report last month. At the start of this year, an investor might only be granted 10-to-1 leverage, and pay 20 basis points above Libor.
To earn the same 12.5 percent returns generated when spreads were at about 0.25 percentage point a year ago, a leveraged portfolio manager would need spreads of about 0.93 percentage point, according to JPMorgan.
“We’ve got to stop being so afraid,’’ New York University’s Smith said, invoking the words of U.S. President Franklin D. Roosevelt at his 1933 inaugural address during the Great Depression. “When Roosevelt said, ‘We have nothing to fear but fear itself,’ he said it in the context of the banking crisis.’’
To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net; Caroline Salas in New York at csalas1@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net
Last Updated: February 20, 2008 12:15 EST
