Collateralized loan obligations comprised of middle-market loans from bank portfolios, a rare sight to date, could amount to billions of dollars this year as banks in the U.S. and abroad look to remove the balance-sheet risks through either synthetic or cash-flow structures. With the Bank for International Settlements increasing pressure on banks to understand credit, and many of the larger loans now off the balance sheet, bank credit officers are turning their attention to the middle-market loan portfolio, explained Jeremy Gluck, managing director at Moody's Investors Service. The big area for potential growth is banks securitizing their own middle-market loans, he stated, whereas in the past independent managers have been the active players.
Elizabeth Russotto, director at Fitch Ratings, said Fitch has rated two CLOs comprised of middle-market loans from specialty lenders, but there is a great deal more interest right now, including from the large commercial banks. The move has not taken off before as banks have focused on reducing loan exposure through tackling the bigger loans first, Gluck said. Though the risk removal of the biggest loans is far from complete, banks are far enough down the road to look at other assets, he added. Furthermore, the loans are largely unrated, a block to CLO activity. But technology is increasingly available to banks to now effectively rate them, Gluck explained. The Basel accord, around the corner in 2005, will set capital adequacy ratios for commercial banks' credit risk. Banks looking to increase middle-market lending can use CLOs to remove exposure to the market from the balance sheet, reducing costs associated with meeting capital allocation requirements.
Robert Radway, managing director and president of Merrill Lynch Capital, agrees with the assessment that CLOs in the area are set to grow, and added, "middle-market loans are extremely suitable for the CLO structure," noting the diversified range of assets and small sizes of the loans available. Russotto, notes that in addition to the diversified assets, the recovery values are very good and the spreads are relatively rich. The pricing on MCG Commercial Loan Trust 2001-1, which closed in December 2001 and ACAS Business Loan Trust 2001, is a bit wider than traditional high-yield, she said. One difficulty to date has been finding equity and investors for the lower tranches, Radway commented, an issue non-specific to middle-market loans. "If you are left with the bottom tranches, where is the risk transfer," he said. He declined comment on Merrill Lynch specific activities.