Current loan liquidity crisis expected to go on for several months, panelists say in TMA Webinar

By Sara Rosenberg

New York, Sept. 19 - The current liquidity crisis in the leveraged loan market is anticipated to continue for at least several months due to the shortage of new CLOs and mutual fund outflows, meaning that the institutional market could remain sluggish and spreads may widen some more, panelists said in the Wednesday TMA Webinar "Current State of the Loan Markets: Hiccup, Turmoil or Credit Crunch?"

Currently, in the institutional market, new issue activity has virtually stopped and demand has evaporated due to this shortage of cash and this inability to raise new CLOs.

As a result of the liquidity squeeze, new issue spreads have widened. Selling pressure has led to a rapid sell-off in both the cash and derivatives market.

This shortage of new cash comes in the midst of a record level of new financings in the forward calendar - roughly $250 billion.

Accessing the institutional market in the foreseeable future will be extremely difficult, making bidding on new acquisition financings of any significant size a difficult process for banks and investment banks.

And, plenty of market liquidity is taking a wait-and-see approach. Postponed/canceled volume increased to $28 billion in August from $3 billion in June, not including transactions that were rated and funded, but not syndicated.

As for the secondary, prices for loans have reached new record low prices as forced sellers, such as warehouse lines and prime rate funds, seek liquidity with a dearth of new buyers.

Current crunch not as bad as historical fall outs

The volatility in the loan market really began around July on jitters over subprime when Bear Stearns said that two hedge funds invested in that sector were virtually worthless. Default insurance costs soared and spreads on dollar junk debt over U.S. Treasuries were up 182 basis points to 474 bps.

However, looking back at other credit crunches, the premium on the spread that issuers are paying is not as bad as what was seen in the past, possibly because the loan market is at a historically low default rate of 0.42%.

For example, in May to November of 2002, as WorldCom filed for bankruptcy just six months after Enron went bust, spreads on dollar junk debt over U.S. Treasuries were up 441 bps to 1,096 bps. At October 2002, the default rate was 5.23%.

In January 2000 to October 2001, during which Nasdaq peaked in March 2000 leading to a two-year bear market in world stocks and the United States was hit by Sept 11, 2001 attacks, spreads on dollar junk debt over U.S. Treasuries were up 475 bps to 951 bps. At March 2000, the default rate was 3.86% and at October 2001, the default rate was 5.75%.

LBO market backing off

With institutional investors backing away from the loan market, the pace of leveraged buyout activity has slowed down, panelists said in the call.

During the first half of the year, the LBO market had been at fever pace in the, with public-to-private transactions dominating LBO activity.

But, the spillover from the subprime market has grounded the hot CLO market, which fueled the LBO market.

Transactions are being put on hold or renegotiated with sponsors, and some are being sold discreetly to hedge funds on a deeply discounted basis.

Covenant-light no more

Covenant-light loans are not being seen in the current market environment like they were just a short while ago.

In the past month, the covenant-light market has come to a halt after $104 billion of covenant-light volume in the first half.

Selling pressure on covenant-light deals in the secondary market has resulted in widening of discounted spread between covenant-heavy and covenant-light deals.

Second-lien spreads widen

The recent volatility has also resulted in the widening of second-lien loan spreads from historical lows set in the first quarter.

In addition, arrangers are offering deep discounts in order to ensure the deals clear the market.

Other structural changes include more restrictive call language, such as non-call periods and higher or longer prepayment fees.

New issue activity on the second-lien front has slowed considerably.

Pro-rata market still approachable

As a result of the institutional market being virtually shut down, arrangers are now revising structures in order to tap into the bank market.

In the past two months, there has been over $5 billion in all pro-rata financings, and despite the recent increase in spreads, they remain at near historical lows.

However, this shift to banks from institutional investors is not expected to last forever. The expectation is that the loan market will be back to an institutional dominated market at some point, but when that will happen still remains to be seen.

"The institutional market will find its legs again. I don't know when, but I don't think it will be this year," one panelist remarked during the call.

Asset-based market remains strong

The asset-based market has not been directly impacted by the liquidity issues in the broader loan and bond market. Because this is not a credit-driven phenomenon, portfolios remain strong and there is no anticipation of a near-term increase in non-performing assets or restructurings.

However, as pricing widens across the broader leveraged loan market, many accounts are hoping to see increased pricing and tighter terms in the asset-based market. This will be particularly true for larger transactions, which require broader syndication. It will likely not impact smaller, single-bank loans and club syndications to the same extent. Risky sectors, including automotive and housing, could become more difficult for the bank affiliate lenders to support in large numbers.

Also, the number of broadly syndicated asset-based loan opportunities may diminish with the reduced merger and acquisition activity, particularly where the remainder of the financing requires an institutional term loan or a bond. This, in turn, could result in increased competition for the available opportunities.

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