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Why Cheap Loans Won't Sell

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Deleveraging a problem for years to come.

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There are a lot of a collateralized loan obligation funds, or CLOs, in the Shadow Banking System. Typically, they buy certain types of debt, a lot of which is in the bank loan space. In the "old" days, banks would make loans to corporations and then sell them to CLOs and other institutions, making a spread on the loan and a profit on the servicing business. Some funds would typically leverage up somewhat and make a decent return.

Today, many highly rated loans are selling for 80 cents on the dollar. There is nothing wrong with the collateral or the corporation that owes the money; there is just no one with ready cash to buy the loans. I asked a friend in the business why he doesn't buy them, considering that they offer very good returns.

The problem is that his fund, and most other CLOs, have covenants in their offering documents that prevent them from buying debt at less than 85 cents on the dollar. That covenant is a good thing in normal markets. It prevents possible mischief by the manager. But right now it means that a lot of opportunity is being missed.

The only way my friend can buy these highly undervalued bank loans is to create a new fund. But getting the money is tough. The pension funds and endowments that would normally be the investors are waiting for cash to come from redemptions in other funds that are, of course, selling whatever they can to raise money for the redemptions, including these very same bank loans. Can you say vicious circle?

The good news is that the market is (albeit slowly) responding to low prices and a market for undervalued assets. The bad news is that it could be months before there will be meaningful recovery in asset prices. In the meantime, these and many other assets are being marked down and impairing the balance sheet of a lot of banks, funds and institutions.

As an aside, the prices for loans made for leverage buyouts in the last few years have fallen significantly. Anybody want to buy some loans made on the Chrysler sale to private equity fund Cerberus? I think not. Just because a loan is cheap does not mean it is necessarily a reasonable value.

Commercial Property Loans Start to Haunt the Banks

There are two aspects to the current recession and financial crisis. The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.

The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages and especially commercial property mortgages all suffer during a recession. Default rates are soaring on all types of consumer loans. That is what you would expect to happen in a recession.

The problem is that many of the larger banks have already had their capital depleted dealing with the credit crisis. Now they are going to have to raise even more capital (or reduce lending) to deal with the normal loan problems that come with a recession.
No positions in stocks mentioned.

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