Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

So Now What for a Shut-Down CDO Sector??

The morning of Thursday, July 26th began with a front page story in The Wall Street Journal entitled Banks Delay Sale of Chrysler Debt As Market Stalls. Written by reporters Dennis K. Berman, Serena Ng and Gina Chon, this WSJ article starts with:

Wall Street's corporate-debt machine has helped to finance the increasingly exotic takeover deals of the buyout boom and to shore up some of the nation's ailing industries with cheap loans and bonds. Now, that machine is sputtering. {Wednesday July 25th 2007], Chrysler Group became a signpost for the high-yield-debt market's strain as bankers for the ailing auto giant postponed a $12 billion sale of debt to investors as part of a buyout severing Chrysler from German parent DaimlerChrysler AG.

The article goes on to highlight that the "debt markets have been chaotic for weeks, as investors coped with more than $200 billion of deals waiting to get funded."

There is also nervousness about how much risk the market can bear. While corporate defaults still hover near record lows, the recent turmoil in the sub-prime mortgage market illustrates how quickly conditions can change.

[Wednesday''s] setback doesn't necessarily mean the buyout boom is over. Bankers managed to sell investors $325 million in junk bonds to fund Dubai Aerospace Enterprise Ltd.'s $1.9 billion purchase of two aircraft servicing companies from the Carlyle Group LP, though they postponed a separate sale of $937 million in loans tied to the same deal.

But with banks now sitting on an expanding pile of unwanted loans and high-yield bonds, Wall Street's top bankers have begun to acknowledge that deals will get more expensive.

That means the five-year run of leveraged buyouts that has poured cash into struggling industries like automobiles and newspapers, will slow considerably. Most of those takeovers were fueled by large sums of money borrowed at low interest rates.

The market's new wariness is already redefining the standards of the buyout game, which once let private-equity firms dictate terms to banks, while using the easy availability of debt to finance ever-richer offers for takeover targets.

"Prices have gotten much higher than historical trading levels for many of these companies," said Scott Sperling, co-president of buyout firm Thomas H. Lee Partners, in an interview. "That's probably not sustainable if debt markets adjust to more normalized levels."

This Wall Street Journal article concludes with the ominous note:

One top lender said it would be possible over the next few weeks to stage leveraged buyouts of at least $10 billion, and perhaps as large as $15 billion. That's a far cry from the $50 billion deals some envisioned a few weeks ago, but still far from a moribund market. Others said it would be months before there was real clarity about the market's appetite.

The market could tighten further, pinching banks hoping for an easier fund-raising environment in September. In one notable development, issuance of investments called collateralized loan obligations has waned sharply. CLOs, as they are known on Wall Street, hold large numbers of corporate loans, the same way a mutual fund holds securities like stocks. The decline in demand for these products could be a sign of a deeper downturn in investor demand for corporate debt. [TCM underline and emphasis added]

Perhaps these Wall Street Journal reporters were trying to be kind about the CLOs and Collateralized Debt Obligations ("CDOs") sector. The CLO/CDO sector has essentially shut down, at least through Labor Day, if not for a much longer period.

Toomre Capital Markets LLC ("TCM") strongly feels the July 2007 mark-to-model valuation exercise is going to be more challenging than what was experienced at the June 2007 month-end. The August 2007 mark-to-model valuations are going to be even yet more difficult because the low transaction volume is very likely to be coupled with the typical summer doldrums as various traders, analysts, portfolio managers and quantitative researchers head off for summer vacations. However, if CDO market activity does not pick up after Labor Day, one should expect the September 2007 valuation exercise to be absolutely brutal.

Are you as an investor ready for your positions to be marked down by 20% or more? Did you really buy AAA or other high-grade securities near par with the expectation that they never would lose so much market value? What should one do now?

Toomre Capital Markets has a few ideas, but first welcomes the reader's thoughts and comments.