Remember CLOs, CDOs? They're Back, Signaling Return to 2004
Structured finance deals of a type last seen before the financial crisis are set to come back in 2013, according to market experts, as a nascent credit boom, coupled with low interest rates, spurs banks and investment firms to test the market for high-yielding, riskier assets.
Speaking to CNBC's "Worldwide Exchange", Brian Reynolds, chief market strategist at Rosenblatt Securities, forecast a resurrection in issuance of CDOs (collateralized debt obligations), an asset-backed security that gained notoriety during the financial crisis in 2008.
"The big story this year has not been the record issuance of corporate bonds – that is a big story in and of itself – but because demand is outstripping supply, we have begun to shift to structured finance," Reynolds told CNBC on Wednesday.
"At the end of last year we started to see a surge in CLO [collateralized loan obligation] issuance, and now we are going to start to see a surge in CDO issuance. These are the same instruments that were used in the last credit boom, which turned out to be one of the greatest credit booms in history, from 2003 to 2007."
CDOs, which are collateralized against an asset pool comprising of a variety of bonds and other fixed income securities, were blamed for the 2008 financial crisis. Investors purchase a "tranche" of the CDO comprising different types of debt with varying degrees of credit risk. The riskier the tranche, the more it pays.
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Last week, the Frankfurter Allgemeine Zeitung reported that Germany's Deutsche Bank had recently launched a CDO worth $8.7 billion, citing sources it did not identify. The German newspaper said the investors – who were all institutional – would receive interest of between 8 percent and 14 percent.
"To us, those high yields indicate why we think CDOs will be in demand, but also illustrate the heightened level of risk involved for the financial system," Reynolds wrote in a research note on Monday, commenting on the deal.
"The story noted that Deutsche established its non-core operations unit last week with $125 billion of assets, ranging from securitized positions to a Las Vegas casino, and plans to reduce that to under $70 billion by March, as part of its efforts to raise its capital ratios," Reynolds said.
"The story doesn't explicitly say so, but we believe that means there are more CDOs to come from this bank."
On Thursday, Deutsche Bank released full-year earnings, posting a major loss following writedowns. But shares were 2.5 percent higher after the lender reported better than expected capital ratios.
At its annual press conference following the results, co-CEO Anshu Jain was asked to confirm whether the bank had issued a CDO in order to improve its capital ratio.
Jain replied: "The deal to which I think you are referring, is one where we chose to de-risk our existing assets, to be sold to a highly sophisticated hedge fund, purpose-built to purchase investments like these.
"And the structure that was used, was, I believe, a CDO."
He added: "CDOs themselves are not illegitimate investments. They were the cause of significant losses in the 2005-2008 period, specifically in conjunction with sub-prime CDOs, and some of the selling practices, and who bought them."
While few reports of CDOs from other banks have emerged, several CLOs - which are similar in structure to CDOs, but securitized purely against loans - were launched in January by the likes of Bank of America, Goldman Sachs and Citi. The CLOs ranged in size from $515 million to $1.3 billion.
According to Reuters Loan Pricing Corporation (LPC), CLO issuance in the U.S. reached $6.4 billion this month (as of January 28), versus a monthly average of $7.5 billion in the fourth quarter of 2012.
Meanwhile, London's Financial Times reported on Tuesday that Pramerica and Cairn Capital are vying to be the first to launch a CLO deal in Europe since 2007. Both institutions were major participants in the leveraged loan space prior to 2007.
Pre-crisis, CLOs were often used to fund leveraged buyouts (LBOs), particularly in Europe where the high yield credit space was less developed than in the U.S.
While LBO-related loan volumes remain low, the still-unconsummated leveraged buyout of Dell is seen by some as a precursor to a revival in jumbo-sized deals.
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According to a note from Steven Miller, the head of leveraged research at Standard & Poor's Capital IQ, Dell's purchase price will be around $22 billion, based on market capitalization, meaning the proposed deal will be the largest since 2008.
"While Dell may be an outlier in terms of size (due to Michael Dell's large ownership stake and a potential $1-3 billion investment from Microsoft), arrangers say the pace of front-end activity for deals of $5 billion or more has quickened," wrote Miller in a note last week.
"Players are increasingly optimistic LBO activity will trend higher in the months ahead, making 2013 a more fruitful year for deal-making than 2012."
Outside the LBO space, Reynolds said banks might want to use collateralized deals to shed poor quality assets, in order to meet the higher capital ratios required by regulators since the crisis.
"We are confident that regulators never figured on Deutsche improving their capital ratios by 'selling their assets' by stuffing them into CDOs, an asset class that has been virtually dead for five years," said Reynolds in Monday's note.
"When other banks see how easy it was for Deutsche to raise their capital ratios by stuffing items from the closet into a CDO, they will follow suit."
- By CNBC's Katy Barnato