NYT reports on the looming CLO debacle:

The default rate on leveraged loans and speculative grade bonds is rising rapidly. “We expect the default rate to get to the range of 14 percent by the end of the year,” said Kenneth Emery, a senior vice president of Moody’s. That compares to peak default rates of 10 to 12 percent during the last two recessions, in 1991 and 2001.

That could turn out to be an optimistic forecast. Edward I. Altman, a finance professor at New York University, says he thinks the rate will probably be in the range of 13 to 15 percent, but could go as high as 19 percent this year. If the recession continues into 2010, he fears that year could see a comparable default rate.

How did we get into this mess? The story is remarkably similar to the tale of subprime mortgages. Lenders who were making money by putting the loans into pools [CLOs]became more and more eager to make loans, and less and less concerned about their quality.

Defaults are now rising because of the recession, but the news could get even worse. Unlike most mortgages, leveraged loans and junk bonds are not scheduled to be gradually paid off over the life of the loan. Instead, they come due and must be refinanced. Moody’s reports that leveraged companies need to refinance $26 billion in loans this year, $44 billion in 2010 and $120 billion in 2011. If credit markets remain tight, we could see lots of defaults even among companies that are doing well enough to make their interest payments.

“If they are not around,” asked Mr. Preston, speaking of the C.L.O.’s, “where is the demand to buy loans going to come from?”

We are in for another leg down…

In a new report, Fitch warns investors about CLOs:

“…given the evolution of leveraged loans from a relatively illiquid asset class at the inception of the CLO market to a more actively traded credit product, Fitch questions the practice of accounting for loans at par regardless of the discounted purchase price threshold. There are elements of the current loan market that are not directly addressed through Fitch’s rating criteria, but should not be ignored.”

Remember the recent rush by banks to buy discounted assets on the open market? Although this report was not specifically focused on how banks treat these assets on their balances sheets, if the CLO manager is a bank, it appears possible for the bank to buy-on-the-cheap loans and account for those loans at par rather than the price actually paid.  Note that this activity would not be adjusting values due to the recent relaxation of mark to market by the FASB.  This shenanigan is separate.

Fitch explains:

Discounted security purchases are generally permitted, but holdings beyond 5% of the portfolio notional balance are generally carried at their purchase price for purposes of overcollateralization (OC) tests.

This structural feature reduces the OC credit given to discounted securities and is intended to protect investors from the following:
• Egregious Par Building: Creating credit enhancement by measuring assets purchased at considerable discount to par at par value rather than their purchase price.

• Adverse Selection: Accumulating assets with relatively weaker credit profiles as indicated by lower than average market prices.
While the intention of the discounted security adjustment has merits, Fitch has long identified issues with its practical application.

In today’s environment, in contrast to the par loan market several years ago, almost all loans are trading below 85% of par. As such, most of the leveraged loan universe would be considered as discounted securities. Since managers account for discounted securities at their purchase price rather than par, there is a disincentive for a CLO manager to make substitution trades, which may be needed to improve the credit quality of the underlying pool of loans.