Lehman Lives in CLOs Generating 50% Returns Amid Loans Rally

More than two years after Lehman Brothers Holdings Inc.’s bankruptcy caused the worst financial calamity since the Great Depression, one of its structured products is producing annualized returns exceeding 50 percent.

Gains in the Lehman collateralized loan obligations, which buy high-yield loans and pool them into securities, compare with 12.8 percent for the Standard & Poor’s 500 Index last year. Some notes are paying about 6 percentage points per quarter more than typical CLOs, said people familiar with the situation, who declined to be identified because results are private.

The performance shows how opaque securities blamed for contributing to $2 trillion of writedown and losses at the world’s largest financial institutions and the collapse of the 158-year-old New York firm are now helping spur lending to the companies most in need of credit. Loans with non-investment grade ratings more than doubled last year, while sales of junk bonds rose to a record, according to data compiled by Bloomberg.

“CLOs were highly undervalued by the wide-spread sell-off of pretty much anything that could be prone to being considered ’toxic’,” Gene Phillips, a director at PF2 Securities Evaluations Inc., a structured finance consulting firm in New York, said in an e-mailed comment.

Credit Comeback

The rebound mirrors the comeback across credit markets as the Federal Reserve holds interest rates in a record low range of zero to 0.25 percent and buys $600 billion of Treasuries to spur the economy and inject cash into the bond markets.

Leveraged-loan issuance increased to $385.6 billion in 2010 from $170 billion in 2009, Bloomberg data show. Junk bond sales rose to a record $287.2 billion last year, up from $162.7 billion in 2009. Commercial-mortgage backed securities are poised to climb to $45 billion this year, according to JPMorgan Chase & Co, from $11.5 billion in 2010.

The improvement is contributing to a stronger economy. Gross domestic product may expand 3.2 percent this year and 3.25 percent in 2012, according to the median estimate of at least 80 forecasters surveyed by Bloomberg. The last time growth exceeded 3 percent for two straight years was 2004 and 2005.

Prices of leveraged loans, those rated lower than Baa3 by Moody’s Investors Service and BBB- at Standard & Poor’s, have risen 62.9 percent to an average 96.42 cents on the dollar Feb. 9 from a low of 59.2 cents Dec. 17, 2008, according to the S&P/LSTA U.S. Leveraged Loan 100 Index. The 96.42 cents price is the highest level since November 2007.

Chasing Yields

Increasing demand is allowing borrowers from San Francisco- based retailer Gymboree Corp. to Dunkin’ Brands Inc. in Canton, Massachusetts, to refinance debt. The global default rate dropped to 2.8 percent in January from 13.6 percent in November 2009, according to Moody’s. Ratings on 399 speculative-grade companies were raised by S&P last year, compared with 267 downgrades, data compiled by Bloomberg show.

Where the structured product market “has come back, it is once again chasing yields without consideration of the lack of standards,” said Joshua Rosner, managing director at research firm Graham Fisher & Co. in New York.

CLOs pool high-yield loans and slice them into debt securities of varying risk and return, typically from AAA ratings down to BB. The lowest portion, known as the equity tranche, offers the highest potential returns and the greatest risk because investors are the first to see their interest payouts reduced when loans backing the CLO default.

Buyout Boom

During the leveraged-buyout boom in 2007, $91.1 billion of CLOs backed by widely syndicated loans were sold in the U.S., according to Morgan Stanley. They made up more than 55 percent of the buyers of leveraged loans that year, helping finance $498 billion of LBOs, according to Bloomberg data and the Loan Syndications and Trading Association in New York, citing figures from Wells Fargo & Co., Intex and S&P’s LCD.

After Lehman’s bankruptcy in September 2008, the amount of new CLOs tumbled to $1.22 billion in 2009, Morgan Stanley data show. In the second quarter of that year, 75 percent of U.S. CLOs stopped making full payments to equity holders. Now, about 85 percent are making them, Citigroup Inc. said in a Jan. 26 report.

In a typical CLO, when too many loans default or are downgraded to CCC+ or below -- the lowest speculative-grade tier -- payments slated for equity investors are diverted to holders of the AAA portion. That causes the CLO to shrink.

Lehman’s Wrinkle

Lehman started the first of what are known as PAR CLOs in 2003, creating 24 with an initial total of about $10.1 billion in assets that are rated by Moody’s. They’re managed by Boston- based Eaton Vance Corp., ING Investment Management Co. and other money managers.

In PAR CLOs, when a default occurs or a loan is sold at a discount, the manager is required to divert payments from equity holders to buy new loans, keeping the pool from getting significantly smaller. That meant that managers were buying loans when prices were the most depressed. With the market reviving, some of those managers are reaping the biggest returns.

PAR CLOs managed by Gulf Stream Asset Management LLC paid its equity investors annualized returns ranging from about 25 percent to more than 50 percent in recent quarters, Mark Mahoney, president of the firm, said in an e-mailed statement. Charlotte, North Carolina-based Gulf Stream oversees 10 CLOs with a total face value of about $3.4 billion.

‘Superior’ Results

“The PAR structures we manage were structured for highly sophisticated institutional investors who understood that while distributions may be diverted earlier than in standard structures, the opportunity to re-invest that cash in cheaper collateral created the potential for superior longer-term results,” Mahoney said.

Some of the Lehman deals have produced recent quarterly returns of about 11 percent, said the people familiar with the results, who declined to be identified because the details are private.

“There was some uncertainty about how this particular deal structure would perform in a recession given the higher leverage, but if you were able to avoid losses, then it weathered the storm very well,” said Jeff Bakalar, a senior vice president and group head at ING Investment in Scottsdale, Arizona, which oversees about $10 billion.

Equity returns for 524 U.S. CLOs in the fourth quarter of 2010 averaged 4.78 percent, compared with 3.95 percent for the year and 3.85 percent in 2009, according to Ratul Roy, managing director for structured credit strategy at Citigroup in New York.

‘CLOs Have Worked’

“CLOs have worked as they were designed and the PAR structures have recently experienced even greater returns due to the structural provisions, which keep leverage at higher levels,” said Michael Kinahan, a fund manager at Eaton Vance. The firm had $188.7 billion under management as of Dec. 31, of which about $22.7 billion was leveraged loans.

The highest-rated portions of CLOs were trading at 94.25 cents Jan. 27, up from a low of 69 cents in April 2009, according to Morgan Stanley data.

Yield spreads on AAA rated pieces contracted to 175 basis points more than the London interbank offered rate as of Jan. 27 from a high of 725 basis points in April 2009, the data show. Spreads were as narrow as 23 basis points in 2007. Libor is the rate banks charge to lend to each other.

In the last week of January, Bank of America Corp. and Citigroup raised $810 million for two separate CLOs. Bank of America priced the $410 million Ares XVI CLO for Ares Management LLC, and Citigroup arranged the $400 million Fraser Sullivan CLO V for WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the transactions. Morgan Stanley priced a $413 million CLO for Oak Hill Advisors LP.

Morgan Stanley predicted in a December report that $15 billion to $20 billion of the securities will be created in 2011.

To contact the reporter on this story: Kristen Haunss in New York at khaunss@bloomberg.net

To contact the editor responsible for this story: Faris Khan at fkhan33@bloomberg.net

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