The Next Shoe Just Dropped: Equity NAVs Of 348 CLOs Slide Below Zero; "Market Changed Dramatically In 6 Weeks"

Tyler Durden's picture

At the peak of the last financial crisis, as the credit liquidation wave was jumping from one highly levered product to the next, one of the hardest hit sectors was the Collateralized Loan Obligations (CLO) space, where the rout and massive P&L losses across most tranches led to a revulsion for new issuance, which effectively shut down the sector for the next 3 years.

However, as central banks pumped trillions into the market, it ultimately found its way back into the new and improved, or 2.0, CLO market, where the resurgent euphoria led  to a record $124.1 billion in new CLO issuance in 2014, with 2015 tailing modestly with $97.3 billion as the second busiest year for CLO issuance in US history and surpassing the last bubble peak.

The problem is that with much of loan issuance in recent years going to the lately very troubled energy companies, it now appears that the second CLO explosion in 10 years may be on deck.

As Reuters reports, downgrades to energy companies' credit ratings are weighing on Collateralized Loan Obligations (CLO) funds' portfolios, in another hit to a market already facing a drop of more than 50% in issuance this year. According to a report issued by S&P, the credit quality of CLO assets is deteriorating, the result of 45 energy borrower downgrades this month as oil prices remain around all-time lows. S&P notes that the credit ratings of around 1.4% of assets held by US CLOs have been downgraded or placed on credit watch with negative implications this year.

To be sure, the S&P report comes well after the market itself has figured out the latent risk in CLOs, as the following performance chart clearly shows:

According to Morgan Stanley, while the pain is spread out across all tranches, it is most acute in the single-B layer. From MS:

Distress in US CLO Market Continued in January 2016. Based on our sample, we estimate that the median total return for US CLO 2.0 (2014-15 vintage) BBs is -9.2%, and for single-Bs is -20.9%. Investment-grade US CLO tranches performed better but still within negative total return territory, except for AAAs. Collectively, US CLOs significantly underperformed relative to comparably rated corporate bonds, leveraged loans and senior tranches of CMBS.

Worse, the sudden repricing means that the negative total returns of US CLO BBs and single-Bs in January have already been more severe than those realized in the entire year of 2015.

It also means that the CLO revulsion is only just starting, and sure enough S&P has finally caught on, with its usual "fashionable delay."

The implications is that with the CLO product suddenly abandoned, lower issuance of CLOs, the main buyers of leveraged loans, will make it harder for companies to issue new debt in the already-challenged US$870bn US leveraged loan market which provides junk loans to companies including retailer Dollar Tree and countless near-distress shale companies.

A quick prime on the current iteration of the collateralized loan oblitation market: CLOs are typically allowed to hold around 7.5% of loans with ratings of Caa1/CCC+ or lower, according to Deutsche Bank, which makes mass credit downgrades difficult for some managers. About 15% of funds have lower limits of 5%.

When low-rated loans exceed those limits, CLOs get a haircut in overcollateralization (OC) tests, which mean that the loans may have to be marked down to market value rather than par or face value. The test measures the value of funds' assets compared to its debt and if CLOs fail, interest proceeds are used to repay debt investors. CLOs pool loans of different credit quality and sell slices of the fund of varying seniority, from Triple A to B, to investors such as insurance companies. The equity slice, the most junior and riskiest part of the fund, is paid last after bondholders.

Among the S&P report findings is that 209 US CLOs issued since the credit crisis have an average exposure of 0.69% to one or more of the 45 companies downgraded by S&P. Among these are Fieldwood Energy, held by 140 CLOs, which was downgraded to CCC from B. Templar Energy is held by 72 funds and had its rating cut to CCC- from B-.

“A number of names have been lowered to the CCC bucket, which could affect OC tests if the CCC thresholds are breached,” said Jimmy Kobylinski, an S&P analyst.

It's just the beginning: as the number of downgrades rises, CLO impairments will propagate in an exponential fashion. Already the number of companies with a low B3 rating and a negative outlook or lower rose to 264 as of February 1, just 27 issuers below an all-time high in April 2009, according to a February 3 note from Moody’s. Oil and gas borrowers make up 28% of the list. 

The growing list, formerly known as the “Bottom Rung,” shows deteriorating credit quality and points to a rising default rate in 2016, Moody’s analysts said. The ratings firm is expecting the US speculative-grade default rate to rise to 4.5% in 2016.

Heavy energy exposure is also starting to weigh on CLO ratings, Reuters adds. A tranche of a post-crisis CLO was downgraded last month when S&P cut the Class E notes of Silvermine Capital Management’s ECP 2013-5 to B- from B. Analysts said that the fund had credit deterioration in the collateral portfolio and a large exposure to the energy sector.

It has gotten so bad that Wall Street, which traditionally has no idea what is going on until it is too late (and then rushes to blame the rating agencies) has started asking questions: "People are definitely trying to get their heads around what [increased CCC holdings] says about the credit cycle,” said Chris Flanagan, head of US mortgage and structured finance research at Bank of America Merrill Lynch in New York. “The market has changed dramatically in just six weeks.

*  *  *

To help the market appreciate the severity of the above, according to a recent update from Morgan Stanley, 2015 was the first post-crisis year in which distress in the CLO market surged. During this year, CLO equity turned from a well-sought, 10%+ return asset class into a space red-flagged with cautions and concerns. While cash distributions managed to remain at ~20% annualized, NAV collapsed across all vintages with the pain most pronounced in 2013-14 deals, the median NAVs of which currently stand at near-zero levels.

The punchline is that this trend not only continued but accelerated dramatically in January 2016 - median CLO 2.0 equity NAVs tumbled by 9 percentage points, or by 85%, and according to Morgan Stanley calculations as of January 2016, a whopping 348 US CLO 2.0 deals’ equity tranches currently having NAV below zero.

And, as Morgan Stanley concludes, it is about to get much worse:

The research approach we are taking towards CLO equity has shifted from one that evaluates growth and upside to one that looks into distress and potential losses. While we do not expect this theme to change in 2016, we reiterate our view that the levels of distress in the US market may create “option-like” payoffs in CLO equity in the secondary market, especially in deals by managers who are better “credit pickers”.

In short, the next shoe in the credit market has just dropped.

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venturen's picture

It is raining SHOES!

Winston Churchill's picture

More shoes than Immelda Marcos.

Beatscape's picture

Coming soon to a ticker tape near you: The 10(!) times upside Corporate Bond ETF, filled with these toxic CLOs. A fool and his money are soon parted.

johngaltfla's picture

I'm sick and tired of getting hit by falling high heels.

However if it means another 30% haircut in the SPY, I'll tolerate the bruising.

Sages wife's picture

Little disappointed that hillary didn't field a few pumps in Vegas. Jimmy Choo right in the beak.

tc06rtw's picture

 …  there are FEET in those shoes !!

KesselRunin12Parsecs's picture
KesselRunin12Parsecs (not verified) tc06rtw Feb 21, 2016 6:14 PM

Looks like Britney has higher heels than Hillary

knukles's picture

Hey, I gotta idea!  (Always good to hear, no?)
We take the worthless equity layers in all 348 CLO's package them and issue a series of tranches of debt off of 'em.
Just keep in mind, Moody's and S&P's very own ratings standards basically say that if the pool is diversified enough, with enough cushion underneath (lower rated tranches) then the senior layer can receive a AAA rating, etc., etc., etc.
No shit, Kiddies!  That's the way it works.  All we have to do is forecast reasonable recovery periods and rates and vio-fucking-la, we got a sale!

(This is not a joke nor a fairy tale, folks.  That's the way it actually works.)

This has been done (not with totally non performing deals I don't think) but with troubled layers of different deals...
Plus, the NAV of the equity might have fallen below Zero, but it all could still be paying and would not be termed insolvent and cause a liquidation event if the deal is structured as a Book Value Structure as opposed to a Market Value Structure

g'kar's picture

i diversified heavily into death bonds

adanata's picture

....or, stated differently, they can do whatever they like...they simply make up the "rules" because they can buy whatever rules they want, yeah?

It's good to be old....

Farqued Up's picture

MV Structure is an invitation for MARKIT to value them marginally downward and lower tranches to be wiped out before the first monthly statement is issued. Then the fucked investor must go to FINRA for relief thanks to Georgie W taking it out of District Court.

Stay away from Collateralized Everything unless you are an expert, in which case you will know to be in the absolute top tranche. Ken Lewis and BAC officers should all be in orange jumpsuits.

Kefeer's picture

I really appreciate your work; assuming you are this person.


I left comments, but they always disappear on the site for whatever reason.

Calmyourself's picture

It is him and his series " The day the dollar died" is classic..

Kefeer's picture

I also like a guy named Ken Goldberg; his analysis has been pretty good, but you must look at the timeframes he gives and be patient; if you can do that then you can of a few that is right far more than wrong.  (He is no Cramer either or Gartman)


This market is all about Herd Sentiment; find the people that are good at analyzing Herd Sentiment in the sector you want to trade and you will profit.


YouTube has a channel called Market Sentiment and although they block out the specific dates; if you use it as a gauging tool along with Goldberg and sometimes Galt; if all three line up it is almost a certainty.  My opinion based on experience.  I got wrecked last year in the oil patch a hard and costly lesson on stupidity. Now know what stop/loss is for.  Live, learn and move forward and for me; rely on God to see me through as He always has.

Cadavre's picture

Just went in retail ~10K of eagles and looking at EEB. When the EUSA paper tanks, the BRIK wll defy the laws of false nature, and rightfully rise to top.

Problem: When the banks belly-up, understanding is  no mas access to the old SD box, soze guessing it be time to get out shovel and dig hole, when no one be looking, in de back yard?

new game's picture

any size shoe fits the fed. their closet is full of shoes, actually they have shoes from 8 years ago that are piled to the warehouse ceiling. moar warehouse space needed...

Mr. Universe's picture

A monster box of ASE is still under 10K. I noticed one site was offering a free E-book download on how to hide your PM's, I think a row boat sinking was on the cover.

Cadavre's picture

One thing really bugs me. I engineer phynancial software. My ignorance and lack of tenure and vanity of career was the reason I got those gigs. I didn't know shit, therefore I wouldn't be mislead by imprecise understandings. Years back I engineered a derivative trading platform that included forward LIBOR curves and forward credit spreads (it ain't that hard). An by golley that guy could predict the YEN=USD spread, or any other fx 6 mths forward, to de penny for all sorts of bank holiday calendars.

Dat project worked a gaggle of swap critters, swaptions, fixed float  to more exotic FX currency rate swaps And, all those swap critters priced at 100 Million face.

Now all this noise about big bad derivative pop kind-a confuses me, cause the 100M face value all those derivative swaps was FUCKING NOTIONAL. IT DID NOT EXIST. IT WAS JUST A DIMENSIONED VAR (oh year - de system dir var) FOR A COMPUTATION. The only monies to change hands was the difference of the interest values the parties held, if both parties could be either receivers or payers (de receiver was de guy with the lower interest comp). When the terms specifically designated the payor and receiver, and de payor's interest was less than the payee's (de receiver), NO MONEY CHANGED HANDS. There was no principal risk. And, in fact, a lot of those contracts allowed the counter parties to quit the contract, without cause.

So, when so and soze talks about a 250Trillion derivative bubble, is so and soze including the non existent, aka "notional", principal and the fact that a lot of those contracts can be quit without cause?

Is the mongering as it relates to a derivative bubble some kind of economic false flagging?

As Iceland said, we ain't vested in any of them transactions, and therefore, we don't give a fuck about the bond holders, so go talk to the fucking underwriters and the borrowers being phone tagged by collateral callers, and leave us the fuck alone, cause we ain't got no fuck'n dog in the fuck'n show.

Sudden Debt's picture

Is what the people said in the Ukraine when their govenrment shot don that airliner.

Cadavre's picture

it was an accident, the cia said it was putin's plane - no worries - blame the shoot down on putin.

Ain't it funny, it's never Rusia, it's always putin. Like public service employees are defacto countries? Lamestream alwaze be ceasin' to amaxe me.

Some outlets still blurbing soviets when talk`n `bout russia ...

new game's picture

add the media to the most hated list...

DanDaley's picture

It's called synechdoche -a Greek's because Putin embidies all that they fear that Russia could do.

ZH Snob's picture

A deflating credit machine eats up capital like Doritos.

iggenFlot's picture
iggenFlot (not verified) venturen Feb 21, 2016 8:50 PM

Gold is slumping on this awful news. However, it won't be slumping for long. Look for gold to rise above $1,300/oz. by 2040.

It's a rocket ship, bitchez!

OldPhart's picture

I see that silver is currently back to $14.97...I guess the elites finally paid attention.

Soul Glow's picture

Credit must expand to fuel growth in the fiat ponzi.  If credit dries up then the ponzi shell game ends.  Here is the ending.

FreeShitter's picture

April-May timetable for implosion?

El Oregonian's picture


Heck, or even Castrated Loan Obligations...

worbsid's picture

Negative; she is just getting her rug cleaned.  If you need help getting that out of your head ...

Amalgamated Tang's picture

More like March-April, if you've been following Mr. Glow's assessments. 


StackShinyStuff's picture

Shhhh.  Not supposed to talk about that. (See Rule #1 and Rule #2)

Son of Loki's picture

But wait a sec, negative returns are better then no returns at all, right?


I'll have to mention these modern investment vee-hickles to my pension plan advisor. He's very good at negative returns.

ThisIsBob's picture

On the theory that its better to be in the red than to have no ink at all.

new game's picture

some collateral is impaired? really? hey fed board, how is that zirp working again? you think you can own up to this problem for once? yea, your fucking policies creating this ongoing problem? and in your infinete financial wisdom, who benefitted? any officers and ceos take some money off the table and bail? think investigations are appropiate? and the banks that issued these loans, wtf is going to happen? bail the banks again? really? wtf is your problem you mutherfucking cocksucking fuck headed bastards?

scintillator9's picture

I have a feeling it will be much sooner than that.

_ConanTheLibertarian_'s picture

2016 is already a lot more interesting than 2015

SuperRay's picture

Risk is accelerating at an exponential rate, which means that we have a few weeks before it's totally out of control.  Greed is so last week.  FEAR is the new normal.  How big is that exit door?

Winston Churchill's picture

Thats and elevator door, open with no car.

Seasmoke's picture

That's because they somehow were able to kick the can into 2016. It sure doesn't look like kicking into 2017 is a possibility without breaking a lot if bones in foot. 

MrSteve's picture

I saw elsewhere the great observation that the past two presidents with two terms in office were both followed by great market declines. What can we expect at the end of this third, two term president? I'm betting on another major market decline, due to the warm-up were seeing now. History doesn't repeat, it just rhymes.

adanata's picture

Stevie...may I call you that? It doesn't matter who's pretending to be preeeeezzzzeeeedent.... ;-/

lincolnsteffens's picture

Oh shit!! We are living in interesting times.

Money Boo Boo's picture

I distinctly remember in 2010-11 the sell side swearing up and down that by 2015-16 we'd be through the bottom and life would be great again. Why is NOONE going back to their archives (it was all published) and hold these dick smokers accountable for their bullshit!!!  It's all their to be republished with dates etc. WTF!!


Trans-Pacific Partnership is signed, sealed, and right on time to be delivered, so that credit expansion can continue ad infinitum. This deal is designed to mask what is really going on in the economy with moar credit Ponzi schemes. Frankly, given that you are fairly adept at economic analysis I don't get why you are not immediately looking for the Establishment Plan B?


Plan B is the Trans-Pacific Partnership.


Rinse & repeat