By Pierre Paulden and Neil Unmack
Dec. 19 (Bloomberg) -- JPMorgan Chase & Co. is adding to a $14 billion bet on collateralized loan obligations while other investors flee the market amid plummeting prices.
Within the past month, the largest U.S. bank by assets bought about $1.1 billion of the AAA rated portions of the securities for about 80 cents on the dollar, according to a person familiar with the transactions who declined to be identified because the trades were private. The bonds are typically backed by speculative-grade loans used to finance leveraged buyouts.
JPMorgan, based in New York, is buying even as the worst economy since World War II forces Chicago-based newspaper owner Tribune Co. and other companies to default. Standard & Poor’s said this month that lower-rated portions of scores of CLOs may face downgrades due to the “rapid deterioration in the credit quality” of the corporate loans.
“If everything’s fine and the companies pay back their loans, the AAA is paid back at par,” said David Preston, an analyst at Wachovia Corp. in Charlotte, North Carolina. “If the situation gets worse, the bonds get paid back quicker and the yield rises.”
That’s because downgrades may trigger a clause in CLO contracts forcing managers to pay off top-ranked bonds faster, at the expense of lower-rated debt. Those managers include firms such as New York-based Kohlberg, Kravis Roberts & Co., which may see investments and fees decline as underlying loan prices fall.
In Better Shape
JPMorgan, under Chief Executive Officer Jamie Dimon, wrote down $20.5 billion since the start of the credit crisis, less than a third of Citigroup Inc.’s total. It also received $25 billion from the U.S. government’s $700 billion bailout fund.
Dimon, 52, is using this financial strength relative to competitors to bulk up on the best pieces of the high-yield loan pools, just as he took advantage of market turmoil by taking over troubled financial companies Bear Stearns Cos. in March and Washington Mutual Inc. in September. Brian Marchiony, a spokesman for JPMorgan in New York, declined to comment.
“There aren’t enough people with the cash to buy these securities,” said Colin Fleury, a portfolio manager at Henderson Global Investors Ltd. in London, which oversees $80 billion of assets including CLOs. “You need to have a medium-term view because if you want to get your cash back you may struggle to find someone to take you out of the position.”
$14 Billion Stake
JPMorgan bought $200 million of top-rated CLOs last week, after purchasing $900 million in the previous month, according to people familiar with the transaction, who declined to be identified because the details are private. That’s on top of at least $14 billion of such investments the bank already held, according to a third-quarter regulatory filing.
CLOs are a kind of collateralized debt obligation, debt instruments that repackage loans into securities of varying risk that pay investors different yields. The safest AAA notes, as designated by rating companies, yield the lowest returns. The latest purchase by JPMorgan yields between 2.8 percentage points and 4.7 percentage points more than the benchmark London interbank offered rate, or Libor.
The market for the securities ballooned amid the record number of buyouts, with $605.5 billion issued since 2001, according to JPMorgan. The bank has been the biggest arranger of high-risk, high-yield loans from 2001 through 2007, according to Bloomberg data. Money managers, including private equity firms, hedge funds and insurance companies, set up teams to manage the loan pools, growing revenue by charging management fees and earning a return on the stakes of the debt that they kept.
Sales Fell
Then the seizure in credit markets hit and CLO sales fell to $64 billion this year as investors moved to safer government debt. Financial institutions have taken losses and writedowns of about $1 trillion since the start of 2007, according to Bloomberg data.
Yields on top-rated portions of loan pools have climbed to 5 percentage points more than the Libor from 1.85 percentage points in July, JPMorgan data show. Yields rose as loan prices dropped 31 cents this year to a record 63.5 cents on the dollar, according to S&P’s Leveraged Commentary and Data unit.
S&P said Dec. 5 that the lower-rated portions of 127 CLOs managed by firms including KKR and Carlyle Group of Washington may face downgrades.
Even with downgrades rising at a record pace, according to S&P, AAA rated portions of the pools are likely to survive the credit crunch, said James Finkel, chief executive officer of Dynamic Credit Partners, a New York-based investment adviser with $5 billion in assets.
“As the economy worsens, the market may love the CLOs less and the tranches may be downgraded” he said. “But they’re still likely to be paid back.”
Recommending CLOs
More than 90 percent of U.S. companies with ratings below BBB- by S&P and Baa3 by Moody’s Investors Service would need to default before an investor buying top-ranked CLO bonds at 80 cents on the dollar lost money, said Finkel. He said he’s buying AAA rated portions and is recommending the trade to clients.
CLOs can typically hold no more than 7.5 percent of their assets in loans rated CCC or lower without having to book them at market value rather than face value. Falling loan prices and increasing downgrades are causing some loan pools to breach those limits, forcing managers to divert cash or repay senior debt.
Wachovia’s Preston said 14 CLOs are failing tests in this way. The proportion of companies rated lower than CCC+, seven grades below investment grade, nearly doubled to 8.2 percent this month from 4.4 percent in October, according to New York-based S&P. It was 2.7 percent at the end of 2007.
High Default Rates
Recent bankruptcies helped send corporate default rates to their highest level since May 2002, according to S&P. The percentage of loans defaulting rose to 4.11 percent this month, from 0.97 percent last December, S&P said.
Loan downgrades to CCC may increase to 15 to 20 percent of the total outstanding, said Jeffrey Kushner, managing director at investment firm BlueMountain Capital Management LP, whose London unit oversees $5 billion of assets, including corporate loans.
“No CLO manager in the world will be unaffected by the CCC issue,” said Kushner. “Most CLO equity right now is probably worth close to zero.”
The equity portion is the unrated piece that loses money first and is typically owned by pension funds, hedge funds and private-equity firms, because it pays more.
‘Historic’ Price Declines
KKR’s debt-management unit, KKR Financial Holdings LLC, said in a regulatory filing last month that it expects three of five CLOs it issued in 2006 and 2007 to fail valuation tests after declines in loan prices of “historic magnitude.” The San Francisco-based company sold pools of high-yield loans to fund the purchase of more than $8 billion of leveraged, or speculative grade, loans.
A KKR affiliate invested $525.4 million in the “junior notes,” the company’s November regulatory filing said. Interest payments from the loans the private-equity firm bought will likely be directed to paying down the top-rated slices of the CLOs, according to a KKR Financial conference call with analysts on Dec. 16.
KKR Financial replaced Chief Executive Officer Saturnino Fanlo Dec. 15 after losing 95 percent of its value this year on the New York Stock Exchange. David Lilly, a New York-based spokesman for KKR, declined to comment.
Carlyle “assembled the assets in the CLO portfolios in a way to perform through a recession,” said Michael Zupon, head of the company’s U.S. leveraged finance team in New York. He wouldn’t comment on the performance of the loan pools.
To contact the reporters for this story: Pierre Paulden in New York at ppaulden@bloomberg.net; Neil Unmack in London nunmack@bloomberg.net
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