Since NatWest first parcelled up some of its corporate loan
portfolio via the Rose transaction, collateralised loan obligations
have been issued by a swathe of international banks. Precise
motivations vary, but most originators are attempting to use CLOs
to gain flexibility in managing portfolios and slimming the amount
of regulatory capital required.
But the route taken to those goals often varies considerably, with
funded securitisations jostling with synthetic securitisations for
attention. Further structural innovation beckons, as Jon Hay
The asset-backed securities market has been growing steadily for
20 years, swelled by new issuers from an ever greater range of
countries and industries. But one type of transaction has
catapulted securitisation to the top of the agenda for directors of
the world's biggest banks - the collateralised loan
Since NatWest launched its $5bn Rose Funding transaction in October 1996, international banks have seized on the idea of securitising large, diversified portfolios of corporate loans, and over 20 European, Japanese and North American institutions have completed deals.
Rose had introduced a new solution to a long-standing problem - how to add liquidity to commercial loan portfolios.
"Banks are very good at originating credit risk, but very bad at holding it long term," says Oldrich Masek, vice president in JP Morgan's London structured products group. "They have strong relationships with corporate clients, and long experience of assessing credit risk, so it is easy for them to lend. Banks also have ready and cheap access to liquidity, so they can lend at short notice. But the regulatory capital they have to hold against loans makes it inefficient for them to just accumulate loans on-balance sheet."
Corporate lending has long been an uncomfortable business for top commercial banks. Throughout the 1980s and 1990s they have been striving to reinvent themselves as investment banks, offering capital markets, derivatives and advisory services as well as their traditional core products - loans, credit facilities and trade finance.
By acting as intermediaries between corporate clients and capital market investors, banks can earn much higher fees without having to increase their capital significantly. Fuelled by the growth of institutionally managed funds, the capital markets are expanding, and there is plenty of market share for the new breed of universal banks.
Commercial lending, on the other hand, is a mature market, even in many developing economies in Asia and Latin America. Loans are in plentiful supply, and competition has driven pricing ever tighter. Once a mainstay of banks' revenue, corporate lending has become one of their least profitable businesses.
As banking becomes more competitive and international, banks are under increasing pressure to reduce costs and broaden their geographical reach and range of products.
This trend has led to a spate of bank mergers that shows no sign of slowing down. Bank managements contemplating a merger, or afraid that they may become a takeover target, are particularly keen to satisfy their shareholders and optimise their bargaining power in any merger negotiations - both of those concerns have made them anxious to improve return on equity.
Yet many banks are locked into huge corporate lending businesses which yield very low returns - and the economic disadvantages of lending are compounded by Bank of International Settlements capital adequacy rules, which require that banks hold capital equal to at least 8% of their corporate loan assets.
"Capital adequacy policy is a blunt instrument," says one senior securitisation official at a US investment bank. "Banks can score the riskiness of their assets internally, and model the risk mitigation effects of holding a diversified portfolio, but the BIS still insists on 8% across the board. The regulations build in an inefficient use of capital, and an artificially low return on equity."
The logic is clear - to increase returns, banks have to reduce the assets they hold, either by lending more selectively, or by removing existing loans from the balance sheet.
"Banks want to keep lending, to maintain the relationships with their clients," says Richard Sullivan, head of securitisation at Tokyo-Mitsubishi International.
"They have always justified it by arguing that lending to a client will enable them to secure other, more profitable business - but it's a moot point whether that strategy works. Even if it does, the banks are accumulating 100% risk weighted assets with low returns."
Banks have limited the amount of loan exposure they carry by selling down as much as possible of a loan during syndication, and by issuing participations - contracts which allow them to remain the lender of record, while transferring the risk, return and capital burden of a loan to another bank.
But these techniques only shift one credit exposure at a time, and rely on finding other banks willing to take on a loan without deriving any relationship benefit.
In the last few years, banks have developed credit derivatives as a more efficient way of passing on their exposure. "Loans are often hedged in credit derivative land before syndication has even closed," says Masek at JP Morgan.
"It started with one-off hedges of single credits - then people began to put together baskets of risks. Credit derivatives are basically participations, but unfunded, and standardised to make them more tradable."
An institution that takes credit exposure with a derivative does not pay the value of the exposure up front, but guarantees the originator against a default. The market prices this insurance according to internal supply and demand, without being tied to the interest on the underlying loan.
One important drawback, however, is that bank regulators are wary of credit derivatives. Policies vary from country to country, but until very recently most regulators would only relieve banks of the capital charge for an exposure if the hedge matched the asset exactly, both in the credit it referred to and in maturity.
The credit derivatives market is evolving fast - technical and regulatory advances, as well as growing familiarity, are likely to improve its usefulness for banks that want to create a liquid market in credit risk.
Most banks' client bases are defined historically, with strong concentrations in particular regions and industries - whereas modern asset management theory calls for investors to diversify their exposure as much as possible.
If banks can originate risk where they have a strong franchise, and pass it on to other banks through a liquid derivatives market, every bank will be able to broaden its credit portfolio and reduce its vulnerability to economic shocks.
But as Masek points out, banks are not necessarily the ideal home for credit risk. "Institutional investors are not covered by the BIS rules, so the capital they have to hold against assets is much closer to the economic capital that the risks truly require," Masek says.
"Ultimately banks will transfer as much credit risk as possible to the capital markets. That will leave them free to do what they do best - assessing credit risk and providing liquidity."
Much of the credit exposure that banks carry consists of revolving lines of credit, providing corporates with the operational flexibility they need.
As the guardians of liquidity in the economy, banks are best placed to shoulder this liquidity risk, and BIS rules allow zero risk weighting for undrawn revolving credits with maturities under one year.
It is drawn loans that generate credit risk, which the capital markets can bear more efficiently.
Against this background, the attractions of collateralised loan obligations stand out sharply. First NatWest, then Bank of Tokyo-Mitsubishi, and in the last year a stream of big-name banks have sold whole swathes of their corporate loan books to capital market investors in single transactions.
The growth has been so rapid, and the deals are so large, that in 1997 some $34bn of CLOs were issued - nearly seven times the volume launched in 1996.
This year so far, CLOs worth some $16bn are known to have been sold, not counting several billion dollars of private transactions.
One of the largest deals this year came from Deutsche Bank. In July the bank issued its first CLO, CORE 1998-1, which parcelled loans to over 4,000 German corporates into Deutschmark and dollar denominated bonds worth a total of $2.4bn.
"Deutsche Bank wants to continue to grow its core lending businesses," says Tamara Adler, head of the European securitisation group at Deutsche in London. "There are more and more opportunities to lend - the question is, how can Deutsche meet them and use its capital most efficiently to support these opportunities?"
In the CORE transaction, Deutsche sold some DM4.26bn of assets to a special purpose vehicle, liberating the regulatory capital it had held against them, worth at least 8% of the total (DM341m).
In place of that, Deutsche will presumably only have to hold some DM75m of capital, equivalent to 100% of the first loss reserve in the special purpose vehicle. The bank can recycle the freed up capital to originate more assets.
Deutsche has set a target of raising its return on regulatory capital to 25% by 2001 - and securitisation will play a central part in achieving that.
"Deutsche will securitise on a regular, programmatic basis, looking at all its assets including corporate loans," says Adler. "We will choose the most efficient structure for each pool of collateral - CORE achieved very attractive capital benefits and cost of funds."
Like every other bank that has issued a CLO, Deutsche used securitisation rather than loan participations or traditional credit hedges, for two interrelated reasons.
Securitisation remodels corporate loans into a form - tradable securities - that institutions other than banks are happy to buy, so greatly expanding the investor base for the assets. And securitisation uses diversification of risk to change unattractive assets into attractive ones.
Most of the corporates whose loans are securitised in a CLO would pay far more interest to issue a bond than to receive a loan, because the bond markets have no obligation to finance them for relationship reasons.
But if a bank can pool 100 or more relatively low-yielding loans, and tranche the exposure into senior and progressively more subordinated bonds, the risk to investors in all but the most junior tranches is greatly reduced, and the yield required to make the bonds attractive falls in parallel.
Hence Deutsche was able to sell over 90% of the exposure to its almost entirely unrated portfolio of borrowers as triple-A rated bonds, yielding between 2bp and 11bp over Libor, depending on currency and maturity.
Banks want CLOs to be large, to increase the volume of loans they transfer - but they also have to be large, so that diversification can mitigate the impact of defaults on any of the underlying loans.
The theoretical advantages for banks in shifting loans off balance sheet and selling them to the capital markets are compelling, and the rapid growth in CLO issuance from $5bn in 1996 to $34bn in 1997 bears witness to the rapid acceptance of the idea.
But it is far from clear whether that growth will continue at the same pace, and whether CLOs will become an everyday part of bank balance sheet management.
Adler at Deutsche is bullish. "Securitisation is now an accepted financing alternative for banks, as opposed to an exception," she says. "It will become as familiar as hedging - banks don't necessarily hedge every exposure, but they always consider it. Securitisation has already taken hold in the real estate market and it will spread to other assets."
Damian Thompson, a director in Duff & Phelps' European structured finance group, agrees: "Every bank in Europe wants to do a CLO.
The continental banks are under intense pressure to improve return on equity, because it is typically lower than in the US and the UK - and they are not just looking at standard corporate loans, but project finance and aircraft loans as well. It's going to be a big asset type, and all the banks want to prove they can do it."
Many of the top investment banks have mandates to execute CLOs. Dresdner Bank is preparing three deals, including one portfolio of German assets, one of pan-European loans, and one comprising loans in some 20 currencies to borrowers all over the world.
Kredietbank is believed to have appointed Lehman Brothers to securitise some of its US loans, and Morgan Stanley Dean Witter is working on a $1.3bn aircraft loan securitisation for Sanwa Bank.
Rabobank's board is considering launching a second CLO, and Banco Santander has filed with the Spanish capital markets regulator for an innovative domestic asset-backed commercial paper conduit backed by loans to small and medium sized Spanish corporates. Securitisation teams at Chase and SG are understood to be structuring the banks' own loans into CLOs.
But the volume of deals actually completed this year has been far lower than many predicted. Turbulence in the capital markets is partly to blame. In March Fuji Bank postponed a $2bn securitisation of Japanese corporate loans just days before launch, as investors shied away from Japanese risk of all kinds.
And as bond markets reeled from Russia's credit collapse in early September, Bank of Tokyo-Mitsubishi and Dai-Ichi Kangyo Bank were forced to pull CLOs worth $2.25bn and just over $1bn respectively, even though the deals were backed by loans to US corporates which are not subsidiaries of Asian companies.
These issuers found that in bearish times, investors were only prepared to buy the most subordinated tranches of the deals at spreads that made the overall cost of funds unattractive.
Sullivan at TMI, which is joint bookrunner on BTM's Millenium deal with JP Morgan, points out another problem: "Japanese banks are at a crossroads. They know they can no longer rely on the domestic economy to drive expansion - so developing the international business is important. But around the world banks are merging, and the Japanese banks may have to face the possibility that they will have to unite with a foreign bank to remain competitive.
"In that context, their position relative to other Japanese banks and their perception in the global banking market becomes very important." Others argue that none of the Japanese banks wants to launch a deal at wide spreads and look like a distressed funder.
These mishaps make it clear that the advantages of CLOs can also count as drawbacks. Accessing the capital markets exposes the issuer to the capital markets' whims, and deals that rely on size to achieve efficiency are particularly vulnerable to volatility.
The non-appearance of the Fuji, BTM and DKB issues also highlights the fact that CLOs' margin of efficiency is narrow. For these banks, the key consideration was cost of funds.
With the premium that investors now demand to finance even the best Japanese credits, and the downward trend in Japanese banks' ratings, CLOs structured to triple-A levels can be a useful source of funds for Japanese banks, apart from the regulatory capital and return on equity benefits.
While the cost of borrowing through a CLO may not beat the issuer's usual funding target basis point for basis point, securitisation opens up a new investor base, without using up credit lines for the selling bank. When widening spreads tarnished the appeal of that source of funds, the three banks judged the deals were no longer worthwhile.
Among non-Japanese banks, CSFB, Credit Suisse Financial Products, Dresdner, Deutsche, JP Morgan and Bank of Montreal have sold public CLOs this year. As Euroweek went to press, UBS was readying itself to return to the market, with CSFP's second deal waiting in the wings.
While these are heavyweight names, the spate of deals last year has yet to turn into a flood. CLOs remain difficult and time consuming to execute. Every bank's loan portfolio is unique, and the mechanics of transferring credit risk vary radically from jurisdiction to jurisdiction.
Since outside the US very few corporates are rated, judging the credit quality of a portfolio can be a complex process, and rating agencies also need to assess the loans by geographical and industry diversification.
More fundamentally, CLOs need to include loans with high enough yields to make the bonds attractive - but on the other hand, if the borrowers' average credit quality is too low, the selling bank will have to retain such a large first loss exposure that the regulatory capital benefit disappears. Once again, the margin of efficiency is narrow.
For highly rated banks accustomed to borrowing through Libor, having to pay coupons above Libor is an added drag on the efficiency of a CLO. In December 1997, JP Morgan introduced a new leveraged structure that enables banks to reduce this burden dramatically.
Special purpose vehicle Bistro issued $697m of triple-A and Ba2 rated five year bullets, and engaged in 300 credit default swaps written by JP Morgan, each of which conveys the risk that an investment grade corporate will default on its senior debt.
Investors' principal is forfeit to the extent of the defaults in the pool. The innovative feature of the deal was that the swaps represent a total exposure of $9.7bn.
In any CLO backed by high quality loans, the vast majority of the exposure can be rated triple-A. Since a triple-A rating denotes virtual risklessness, that portion of the deal achieves very little risk transfer for the selling bank, and is effectively just a more expensive way of funding the loans than the bank's normal borrowing.
JP Morgan's innovation was to split the triple-A exposure into two tranches, and only issue the smaller, subordinated one. Morgan continues to fund the most senior section of the exposure on its balance sheet. Bond proceeds are invested in Treasuries, which will repay the debt, so delinking it from JP Morgan's credit.
There is an extremely remote risk that so many of the underlying corporate borrowers will default that this super senior tranche is affected - but under the Federal Reserve Bank's forward looking approach to capital adequacy, JP Morgan's capital requirements are closer to the economic risk of assets than those of many other banks, and the senior tranche requires very little capital.
JP Morgan has kept the Bistro structure close to its chest, but apart from two issues for its own account, the bank has executed at least three CLOs for other banks using this and related techniques.
"We've done several billions of dollars of this kind of business for clients in Asia, the US and Europe," says Masek.
"The credit derivatives market grew up to manage risk, and CLOs developed to save on regulatory capital. We're marrying the two - trying to create an efficient market for whole portfolios of risk."
The attractions of leveraged CLOs have probably reduced the volume of public deals this year. Commerzbank, for instance, is believed to have privately completed a CLO this spring. But as Euroweek went to press, Warburg Dillon Read was marketing Eisberg - a transaction offering $500m of bonds backed by $5bn of corporate loans on UBS's balance sheet.
This deal would be the most highly publicised leveraged CLO so far, and the first public one not to have been managed by JP Morgan.
A single credit default swap between Eisberg and UBS exposes investors to the risk of a portfolio of corporate risk, whether in the form of loans or derivatives counterparty business.
A state linked bank that is zero risk weighted by Swiss regulators will take on the most senior slice of risk in the deal.
In what is arguably an advance on JP Morgan's original structure, UBS will not have to reveal the names of any of the underlying credits, and will manage the portfolio dynamically, moving individual exposures in and out of Eisberg to suit its balance sheet management needs.
"UBS's business is shifting away from lending," says Peter Shorthouse, head of securitisation at Warburg Dillon Read in London.
"We will continue to lend, possibly in even greater volume, to target clients, or to support core relationships - but there is a lot of peripheral lending that we will exit over time. And those key clients are also those with which we will be doing other credit business like derivatives.
"As our exposure becomes more concentrated, we will have to manage it more and more carefully, to avoid being constrained by credit limits. Eisberg, like the Glacier deal we did last year, is effectively a box that is off balance sheet for regulatory purposes into which we can shift risk when we have too much exposure to that particular credit."
While UBS's structure - delinked from its credit, minimally funded and actively managed - may seem state of the art, it is significant that CSFB, coming to market at the same time, chose a different tack for its $2.5bn Triangle 2 CLO.
Triangle 2 resembles Eisberg in being collateralised by Treasuries and delinked from the seller's credit, using a credit default swap to transfer risk. But the reference credits are all loans, substitution will only be used to preserve the credit quality of the pool, and the deal is not leveraged.
"Investors do not want funky deals at the moment, and this is a very straightforward structure - cleaner, tighter and with fewer moving parts than most CLOs," says a syndicate official at CSFB. Another official at the bank said CSFB had considered a structure closer to UBS's, but found it too expensive.
And Sanwa Bank introduced yet another new structure with its ¥75bn Delphi CLO, launched in late September. Rather than try to delink the vehicle from its own risk, Sanwa opted to keep the loan portfolio on balance sheet unless it actually defaults, and place most of the deal, including all the subordinated notes, with Japanese investors, who have fewer qualms than foreigners about taking the credit risk of a leading Japanese bank. To attract international investors to one tranche of the senior notes, Sanwa enlisted a triple-A rated German state linked bank to guarantee its obligations to Delphi as far as that tranche is concerned.
A wide variety of structures, a moderate volume of deals, issuers' vulnerability to market disruptions - all these characteristics displayed by the CLO market this year tell the same story. It's early days.
Despite the well recognised advantages of CLOs for both issuers and investors, the sector is very different from the major US asset-backed markets, which are characterised by regular issuance, established structures and a solid investor base.
The impressive pipeline of mandates suggests that, in the medium term, CLO issuance will continue to grow. Whether standard structures begin to emerge, enabling investors to assess and value deals more quickly, is far less clear.
Structural innovation shows no sign of slowing down, and the great variety of collateral and intentions between banks will continue to provide ample demand for customised solutions.
CLOs are difficult, and are likely to remain so - difficult to decide to do, difficult to structure and rate, and difficult to sell. The large size that makes them efficient also makes them unwieldy.
"Will CLOs be a really big securitisation market?" asks Shorthouse at Warburg Dillon Read. "The jury's still out. Not all banks have suitable portfolios and systems, and it seems possible that the regulatory arbitrage could disappear in a few years if the BIS changes its rules."
The fundamental direction of the banking industry is becoming ever clearer - banks' credit exposure will become more liquid, and may gravitate away from banks altogether, into the hands of managed funds.
CLOs have given a powerful impetus to the transformation, but it will be a long time before banks can rid themselves of credit risk as easily and effectively as they now hedge interest rate and currency risks - and CLOs may only be one stage in the evolution of that liquid market. EW