Borrowing Cash to Buy Complex Assets Is In Vogue Again


By Katy Burne

Banks again are doling out money to hedge funds and other investors to finance purchases of complex debt securities, returning to a practice that helped fuel the debt boom ahead of the financial crisis.

RBC Capital Markets, Société Générale SA and Wells Fargo & Co. are among the banks offering to let investors borrow money, also known as providing leverage, to buy collateralized loan obligations, say investors and bankers. CLOs are bonds typically backed by pools of low-rated corporate loans.

Borrowing programs for such esoteric securities have been only selectively available in the years since the crisis. While banks have lent to a handful of investors, the practice picked up late last year when funding costs began to fall. Even now, the use of leverage is relatively nascent for these securities.

Banks' increased willingness to lend follows new rules weighing on the $300 billion U.S. CLO market. Many banks own CLOs themselves, holding about $130 billion on their books. New regulations may mean some banks will be forced to sell some CLOs in the next few years.

Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.

Banks "are resorting to creating economic incentives to get primarily hedge funds to step into this void," said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs.

Using borrowed money to buy securities may help hedge funds bolster returns, a useful strategy with interest rates at rock-bottom levels on many other mainstream debt investments.

Many investors steered clear of borrowed money after getting burned in the financial crisis, when they were forced to repay loans on securities whose value had fallen. But several investors said CLO returns wouldn't be attractive now without leverage.

Hedge funds "have finally come to grips with leverage and begun to embrace it" for CLOs, said Jean de Lavalette, head of securitized products sales at Société Générale.

But with leverage comes risk. Even a small drop in the market could force investors to pledge more cash and other collateral to offset the securities' decline. Losses are magnified when borrowed money is used.

"We've always had a real aversion to investments that require that sort of leverage," said Craig Bergstrom, chief investment officer at Corbin Capital Partners, an asset manager overseeing $4 billion, who said he took a pass on the CLO leverage.

Overall, borrowed money is mostly being used to buy triple-A-rated CLOs, say bankers and investors. That contrasts with the run-up to the 2008 crisis, when huge sums were borrowed to finance bets on assets such as subprime mortgages.

Still, regulators cast a wary eye on signs investors are taking on larger risks. A group of about 30 international regulators met in Basel, Switzerland, this year to seek more information about rising leverage in the financial system, including through leveraged loans and CLOs, say people familiar with that meeting.

CLOs performed better in the financial crisis than other esoteric offerings, such as collateralized debt obligations, backed by subprime mortgages. CDO investors suffered heavy losses following rating downgrades and defaults in the crisis, while CLOs were more resilient and suffered comparatively few defaults.

"People learned from the crisis that the availability of leverage shouldn't be the driving factor in an investment decision," said Ryan Atkinson, head of distressed credit and trading risk at RBC Capital Markets, a unit of Royal Bank of Canada. He said he arranged financing for CLOs bought by a handful of hedge funds and others but declined to identify the funds.

GoldenTree Asset Management recently purchased CLOs using leverage. Joe Naggar, a partner at GoldenTree in New York, said using leverage makes sense because prices on highly rated CLOs have fallen, increasing their yield relative to other debt securities. Borrowing money to buy could bolster returns if prices rebound. GoldenTree oversees $3 billion in complex debt such as CLOs. Banks have begun to offer the loans more cheaply and for terms that are several months longer than previous ones, Mr. Naggar said.

Banks have offered to lend some investors as much as $9 for every dollar that the buyers invest in CLOs, say traders and strategists. Others are being offered $8 for every $2.

An investor in a triple-A-rated CLO earning 1.50 percentage point over the London interbank offered rate--using 10% of his or her own money and paying 0.80 percentage point over Libor for the financing--could earn about 8% in a year. That compares with annual interest rates near 2% on a standard triple-A CLO.

Citigroup researchers in a mid-April note to clients predicted that the new source of financing could help drive up prices of triple-A-rated CLOs.

That could be a boon to a market that has stumbled under the threat of new rules on what banks can hold on their books. CLO prices tumbled, and the creation of new CLOs slowed earlier this year as the market digested the rules that will ban banks from investing in certain CLOs.

Since then, CLO prices have begun to recover, and CLO issuance has picked up after a slow start to the year. More than $35 billion of CLOs were created so far in 2014, the most for that period since 2007, when $36.4 billion were created, according to S&P Capital IQ Leveraged Commentary & Data.

A Wells Fargo spokeswoman confirmed the bank had offered leverage for CLOs but declined to elaborate.

Write to Katy Burne at katy.burne@wsj.com

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