MortgageNewsClips welcomes our newest contributor, The Prince of Wall Street 

An interesting article by Vipal Mongra, entitled “In death, afterlife“, appeared in The Deal on Monday speculating about the future for Collateralized Debt Obligations (CDOs).  In the article Messieur Mongra speculates how CDOs may fair in comparison to other products/strategies that were pronounced dead only to rise again from the ashes.  Most notably the article points to how wrong many prognosticators were when the predicted, based on a wave of corporate defaults and broken deals, that LBOs and junk bonds would be gone forever.  The tone of  Mssr. Mongra’s piece seems to suggest that once this turmoil has passed mortgages will begin to be repackaged under a different name than CDOs then sold to investors.  The Prince must mostly disagree with this prediction.  Click here for why.

To read more please follow the link to “Incentives Kiled CDOs but CLOs Will Live”.  Here is another excerpt related to why CLOs will live from the post:

Now CLOs are another story.  Over the summer many CLOs were forced to sell corporate bank debt and high yield debt (mostly related to companies that were taken private) they owned to meet margin calls on the mortgage assets they held.  CLOs were the largest demanders of buyout related debt issuance.  In fact, CLOs represented almost two-thirds of primary demand for loans in the syndication market over the past three years.  They have been absent from the market since the turmoil began this summer.  CLOs will come back because the leveraged loan and high yield corporate debt markets have properly aligned incentives but are merely going through a re-pricing of risk right now.  Investors in these forms of debt are pushing back against the buyout shops and taking aim at the covenant lite/PIK toggle terms of these debt instruments that made them very unappetizing for investors.  There is also certainly a level of contagion going on in the leveraged loan market as well.  Many firms that own buyout related debt may be selling this debt not because they think it has become less valuable but because they must meet margin calls on the their mortgage related portfolios. 

The Prince also believes that since most PE shops got such great terms with wide covenants and PIK toggle characteristics that we will see less corporate defaults by sponsor owned junk rated companies during this cyclical downturn than in past downturns.  To distinguish CDOs from CLOs we need look no further than the fact that CLOs have continued to return money to investors, as the rate of corporate defaults has remained below the 4% historical average.  CLOs have also not had to write down the value of their portfolios since they operate as cash flow vehicles.  Another good example, is the fact that CLOs only buy loans as primary purchasers of whole loans offered by banks that lend to companies or sponsor owned companies.  CLOs do not buy repackaged securities like CDOs did when they bought MBS.  The leveraged loan and high yield debt markets are discounting these securities in anticipation of much higher defaults than The Prince sees on the horizon.  There are probably some good deals available in these two markets for long-term investors if the investors know the credit of the underlying company very well and believe that they will get their payments without a default.  Much of this paper is trading so far off of par that The Prince finds it difficult to think of adverse scenarios in the future which could justify these prices.  CLOs will return, especially those that mainly focused on buying buyout related debt.  The incentives which drive the players in the CLO space are appropriate but those that drove the entities in the CDO market could only lead to ruin.  Let’s just hope the destruction wrought by CDOs does not continue to have knock on effects throughout other parts of the credit markets.

To read more please follow the link to “Incentives Kiled CDOs but CLOs Will Live”

-The Prince