US housing stuck in the doldrums

John O'Brien

Like investors the world over, Americans thought property was gilt-edged, then along came CDOs. Meanwhile, corporate debt just keeps on keeping on. John O’Brien, van Eyk’s head of research, spoke with Philippa Yelland.

As the US economy slowly emerges from the ravages of the Global Financial Crisis brought on, in large part, by the collapse in a collateralised debt obligation (CDO) market that was worth more than $2 trillion at its peak, it is occurring despite the fact that the American housing market remains stubbornly in the doldrums, says O’Brien.

In doing so, it’s revealed one of the great paradoxes of this financial crisis in the US – mortgage-backed securities, and particularly CDOs of mortgage-backed securities, performed much worse than they were supposed to, while collateralised loan obligations (CLOs), backed by corporate debt, have emerged from the GFC in much stronger shape.

“Most analysts are predicting a cumulative drop in US home prices over the next two years,” says O’Brien. “You don’t have to be a genius to figure that out, particularly after riding through suburb after New York suburb littered with ‘for sale’ signs that sit there, day after day, the houses themselves having that abandoned look.”

Home equity loans, in particular, are a total washout, he says, with many pools having defaulted. “For these loans, there’ss safety in numbers: if no one pays, there are too many people for the banks and servicers to go after, and they cannot chase all of them at once,” he says.

“CDOs backed by mortgage securities containing these loans were among the first to underperform in the second half of 2008, with some being liquidated at significant losses, and those remaining have not staged much of a recovery.”

In sharp contrast, CLOs, backed by BB and B syndicated loans, made often to struggling corporations, middle-market companies, and turnaround stories did fairly well through the financial crisis, says O’Brien.

Even though trading spreads on CLOs pushed out briefly to more than 20 per cent above LIBOR at their worst, they came rapidly back in 2009. Corporate loan defaults in the US peaked at just over 10 per cent in early 2009, and have also improved rapidly since then.

In fact, before one of the major rating agencies changed its approach to CLOs (to make it far more conservative), not one AAA or AA CLO tranche was downgraded, O’Brien says. There were some covenant breaches within outstanding CLOs, but these did what they were supposed to do (paying down senior AAA debt and stopping payments to equity), allowing the CLO to be self-correcting.

Rating agencies did adjust their corporate default and recovery assumptions after the worst of corporate defaults in 2009, but in most cases this only pushed most AAA ratings down to AA.

O’Brien says it is is also worth noting that the outlook for leveraged loans, the collateral for all CLOs, remains favourable, despite a very ordinary economic outlook in the US and Europe. “Whereas house prices in most of America continue to go nowhere and there is a huge amount of property that still needs to be sold to correct the market, in leveraged loans it is almost (not quite) back to the days of 2004-2006, when CLO investors could not get enough leveraged loans,” he says.

In that period, at its peak, 70 per cent of the demand for leveraged loans came from CLOs.  That number is down to 45 per cent now, but interestingly, new buyers of CLOs have emerged since then:  hedge funds, which became opportunistic buyers during the credit crisis, accounted for 30 per cent of demand in 2009, and while they purchased opportunistically (in times of wider spreads), they still make up 25 per cent of demand currently.

Banks themselves have also come in for allocations, even if they are not the agent bank or part of the loan syndicate, O’Brien says.

For now, non-investment-grade companies in the US that had been accessing the syndicated loan market for funding are heavily refinancing in the high-yield bond market, where the terms are lighter, their obligations are unsecured, and they can get fixed-rate payments if their treasurers are concerned about rising interest rates (leveraged loans are generally floating rate, although in this low interest rate environment, lenders have been including floor levels on LIBOR itself of 1-2 per cent).

He says this has left CLO managers with a lot of prepayments to re-invest, which accounts, along with hedge funds and banks, for the continued demand.

It wasn’t supposed to work this way, O’Brien says. “Loans to non-investment-grade companies – some rated as low as CCC – were supposed to be more like playing with fire, whereas houses were thought to be solid investments. What’s more, for corporate loans the outcome was normally binary – either the company paid, or it defaulted, in which case investors were generally in a heap of trouble.”

Investors in the first wave of CDOs, which were more often collateralised by high-yield bonds, had found this out the hard way in the recession of 2002-03, when the equity and many of the lower rated tranches of these CBOs were wiped out.

Mortgage and asset-backed securities, on the other hand, were not supposed to default per se – if individual homeowners defaulted, the principal and interest payments would be reduced, but the pools of 300 to up to 1000 loans were not supposed to be put in jeopardy by a single homeowner declaring bankruptcy in Las Vegas.

Only if a large wave of defaults hit would the mortgage-backed security, as a pool of loans, be in serious trouble, O’Brien says.