C&B Notes

A Market Where Fax Machines Still Matter

In the ongoing stretch for yield, the most-often-discussed headline risks are primarily related to credit quality and duration. Many participants are likely underappreciating the structural illiquidity risk in the leveraged loan/CLO market, which will only compound in a crunch. This underappreciation is especially pronounced for those investors who have limited visibility into the underlying assets.

Imagine a trillion-dollar market that runs on faxes and phone calls while routinely tying up investors’ money for months before they get any return.  That’s not fiction: It’s the unregulated market for leveraged corporate loans.  In a financial system that is increasingly automated, the origination and trading of loans is in the relative dark ages while money pours in from mainstream investors such as Kansas and New York pension plans and mutual funds catering to individuals seeking high yields in an era of near-zero interest rates.

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The time it takes to settle a loan has gotten worse since the financial crisis, lengthening to an average 20 days as of June, from 17.8 days in 2007, according to data tracked by the Loan Syndications and Trading Association.  In the high-yield bond market, it generally takes three or fewer days.  When regulators were drafting securities laws more than 70 years ago, company loans were excluded because they were mainly private transactions between one bank and one borrower.  That’s no longer the case, as the debt is mostly syndicated, or distributed, to investors who can then trade the loans among themselves like a bond or a stock…

Investors poured an unprecedented $62.9 billion last year into mutual funds that buy the debt, which is mostly speculative-grade, according to Lipper data.  They have been lured by yields greater than those of higher-rated securities and interest payments that float above benchmark rates — with the latter being an attractive feature amid speculation the Fed may boost borrowing costs next year….

“Pension and retirement funds have poured in for the reason you know: They need yield,” said Erik Gordon, professor at the Ross School of Business at the University of Michigan in Ann Arbor.  The low-rate environment has “forced people’s retirement to be invested in riskier and riskier things and this is an example of a riskier thing.”  Some of the worst delays in settlement times can be found in the market for new loans, where Pimco’s MacLean said it’s not uncommon for months to pass before a purchase is completed.

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One reason there’s little momentum to streamline trading is that Wall Street banks benefit from the status quo, according to Scott Page, director of bank loans at Boston-based mutual fund firm Eaton Vance Corp.  Banks earn fees for committing to fund deals until they close while shifting risk to investors.  “The biggest banks who act as underwriters have an apparent self-interest in maintaining this archaic system,” Page said.  “We are mystified by the fact they seem to have no interest in fixing it.”

JPMorgan and Bank of America Corp., the two biggest underwriters, as well as other big banks, typically earn fees of 1 percent to 5 percent for arranging a leveraged loan, according to Standard & Poor’s data.  That compares with 0.5 percentage point on bonds for investment-grade companies, and 1.3 percent for junk notes last year, Bloomberg data show.

While buyers and sellers can trade stocks and bonds among themselves, they need the approval of corporate borrowers before they can exchange loans.  Clerks must then update loan documents to reflect new lenders.  “People don’t realize that fax machines are still around in this day and age but they are.  With loans, “there’s a high amount of faxing going on still,” said Virginie O’Shea, a senior analyst at Aite Group LLC in London. ”