Here’s an easy read on ABS CLOs, and levered CDOs, the demons that suddenly rule global financial markets.

Barry Sergeant&nbsp|&nbsp@Moneyweb &nbsp|&nbsp30 July 2007&nbsp

Last Thursday’s turbulence in global markets was triggered by news that Chrysler Group and Alliance Boots had withdrawn more than $22bn in loan sales from the market. Despite the backdrop of generally advancing equity markets, for six months investors have increasingly become risk adverse, mainly on the back of the meltdown in the US’s so-called subprime mortgage market.

The good news is that while the Bank Credit Analyst observes that “some contagion” from subprime to the broad credit market is underway, the blowout in subprime spreads over the past six months is unlikely to cause a major problem for higher-quality paper.

Global credit markets have become increasingly complex, and difficult to plumb at times like this. Bill Gross, MD of Pimco, the world’s biggest bond fund, early last week observed that Tim Bond of Barclays Capital has said, a few weeks ago, that it is the excess leverage of the lenders not the borrowers which is the source of systemic problems.

Low policy interest rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximise returns with what they thought were relatively risk-free loans. And this is where the alphabet soup starts. These loans stem from asset-based securities (ABS), most notably collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), and levered CDO structures.

Gross observes that the rating services – such as Standard & Poor’s and Moodys assigned investment grade ratings (the best) to such animals, which then were sold with enticing LIBOR (London inter-bank overnight rate) plus 1%, 2%, 3%, “or more” types of yields.

To pause here, CDO is a general term covering CLOs, collateralised bond obligations (CBOs), and collateralised mortgage obligations. CBOs are classified as investment-grade bonds, and are, ironically, backed by a collection of junk (subprime) bonds, with risk “tiers”, determined by the qualities of junk bonds involved. CBOs backed by very risky junk bonds are, of course, sold at higher interest rates.

A CLO, which is similar to a collateralised mortgage obligation, is backed by pools of commercial or personal loans, structured with several classes (tiers, known here as tranches) of bondholders with varying maturities.

“The bloom came off the rose and the worm started to turn, however,” according to Gross, “when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space.” Gross asks if the same thing is happening to levered structures with pure corporate credit backing?

To be blunt, as Gross puts it, institutional investors seem to be thinking that if the ratings agencies have done “such a lousy job” of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs?

Ailing confidence – with defaults of two Bear Stearns hedge funds in the background has “frozen” future lending, according to Gross, “and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving”.

Within the space of a few weeks, plenty enough has changed. There has been, as BCA Research puts it, “a record-setting rush to issue bonds in order to buyback stocks and finance takeovers in the past year, turbo-charged by the investment stampede into private-equity funds”. The availability of capital is suddenly less certain, following the subprime mortgage meltdown.

The supply of credit to finance deals has suddenly become less plentiful and there is still a considerable amount of leveraged buyout (LBO) debt and loans in the pipeline. Also, while still historically low, the cost of funds has started to rise.

What about hedging against risk in risk markets? There are specialised investors who refer to the Dow Jones CDX Indexes, a series of indices that track North American and emerging-market credit derivative indexes. The idea of the CDX index is to provide a benchmark from a basket of credit derivatives representing certain segments such as US investment grade credit derivatives, high volatility, high yield, high yield non-investment grade, as well as emerging markets.

Credit derivatives, in turn, are defined as privately held negotiable bilateral contracts that allow investors to manage exposure to credit risk. Credit derivatives, which now total tens of trillions of dollars globally, are financial assets not unlike forward contracts, swaps, and options for which pricing is determined by the perceived risk of the underlying agent.

Investors are likely to remain jittery until the dust settles on the alphabet soup currently dominating global markets. As Gross puts it, “the mistrust of rating service ratings, the constipation of the new issue market and the liquidity to hedge the obvious in CDX markets has led to current high yield CDX spreads of 400 basis points or more and bank loan spreads of nearly 300”.