Term Sheet

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

New bait for the old office of JPMorgan's London Whale

July 18, 2013: 1:06 PM ET

Collateralized loan obligations are back, even in the most unlikely places.

130114091939-jpmorgan-monsterFORTUNE -- The former office of JPMorgan Chase's London Whale is diving back into risk.

According to several people familiar with the deals, JPMorgan's London chief investment office, which last year lost more than $6 billion betting on credit derivatives, is in the process of inking deals to buy significant portions of collateralized loan obligations, which are structured bonds that are backed by groups of loans to below investment-grade companies.

John Timperio, a lawyer at Dechert who specializes in CLOs, says he is working on two deals right now in which JPMorgan (JPM) is expected to be the main buyer. One is for loans to mid-sized companies, which carry more risk, but higher yields. In another deal, JPMorgan is planning to buy nearly all of the highest-rated piece of the CLO. "It's a fairly large deal," says Timperio. "JPMorgan is back in this market."

CLOs are not the derivatives that are in part credited with blowing up the mortgage market and are at the heart of a trial going on in lower Manhattan against former Goldman Sachs (GS) banker Fabrice Tourre. Those are collateralized debt obligations, or CDOs, which were backed by subprime home loans. But CLOs are close cousins.

MORE: JPMorgan's London Whale review: Inside Job

Banks make the loans, typically to companies with credit ratings of BBB or lower, and then sell them off to a CLO manager, who, with the help of a bank, packages up those loans into bonds that are sold off in slices based on risk. Despite the lower rating of the original loans, through the magic of securitization, about 60% of the bonds of a typical CLO get an AAA rating, which is the highest.

Issuance of CLOs dried up in mid-2008 along with other structured finance deals. But unlike the risky mortgage deals that were inked during the financial crisis, CLOs have recently made a big comeback. Banks underwrote nearly $44 billion of the leveraged loan deals in the first half of the year, according to Thomson Reuters. That's up from $17 billion in the first half of 2011, and $11 billion in the year before that. The CLO market has slowed a little bit in the past month as interest rates have risen, but it's still on pace to nearly match the $92 billion in CLOs that were issued in 2007 when the market peaked.

Perhaps the most surprising thing about the CLO revival is this: The entities that have emerged as the biggest buyers of the packages of risky bank loans are the banks themselves. JPMorgan holds more CLOs than any of its rivals. In the past two years, the bank has nearly doubled its holdings of CLOs to $27 billion, as of the end of the first quarter, which was the last time it disclosed its holdings. According to its filings, the CLOs were purchased by JPMorgan's chief investment office, which is the unit where Bruno Iksil, who was nicknamed the London Whale, worked. Three people confirmed that JPMorgan manages its CLO portfolio out of its London office. JPMorgan's CIO unit, which invests the bank's excess reserves, is now headed by Craig Delany, who took over for long-time CIO chief Ina Drew, who left shortly after the bank's multi-billion losses were revealed. JPMorgan slowed its CLO purchases in the wake of those losses. But it appears the bank is in the process of ramping up their purchases again.

Wells Fargo (WFC) has been a buyer as well. It had $15 billion in CLOs at the end of March, up from $8 billion the year before. Citigroup (C) had about $4.5 billion in CLOs at the end of the first quarter, up from $3 billion the year before. Bank of America (BAC), in contrast, has largely decided to stay out of the CLO investment market. At the end of the first quarter, BofA held just over $700 million in CLOs.

MORE: What could cause the next financial crisis?

"You might look at this behavior and draw the conclusion that big banks are pretty stupid," says Sylvain Raynes, who co-heads R&R Consulting, a firm that examines structured finance deals. "It's like exchanging four quarters for a dollar, except they are only getting back 89 cents. So to the average observer it looks like bankers spend their days running around and doing nothing. But the truth is it's financial regulation that is irrational. Once you factor that in, the banks' behavior makes a lot of sense."

JPMorgan declined to comment on its CLO holdings other than to point to its SEC filings. Wells and Citi also declined to comment. In general, bankers say CLOs offer diversification. And CLOs are popular now because they have floating rates, which means they won't drop in value when interest rates rise. Also, bankers point out that CLOs, unlike other structured products, made it through the financial crisis with few actual losses. That's bolstered their reputation as safe. What's more, CLOs still make up a very small portion of their overall assets, which for the big four banks is over $1 trillion.

But almost everyone in the CLO market, including many bankers, say one of biggest reasons banks are buying CLOs has to do with regulations. Financial reform was supposed to stamp out regulatory arbitrage, in which banks are able to swap one similar asset for another in order to be able to increase their leverage, which generally increases risk.

But that hasn't happened in the CLO market. Under the new capital rules, which were approved by the Federal Reserve in early July, loans to corporations have a risk weighting of 100%. The AAA slices of CLOs, which are the portion of the deals banks typically buy, have a risk weighting of only 20%. That means banks can invest five times as much in CLOs as they can in the underlying high-yield loans with the same amount of capital. The additional funds come from borrowing, which increases a bank's leverage.

Price makes this trade particularly attractive in the CLO market. And it plays into the banks' current search for yield in a low-interest-rate environment. Despite the fact that bankers say the AAA portions of CLOs are relatively safe, the bonds tend to pay considerably higher yields than a similar investment in mortgage backed securities, or bonds that are backed by credit card or auto loans, on which banks would have to hold similar levels of capital. And while few CLO deals ended up blowing up, the prices of the bonds fell sharply during the financial crisis, as the market froze up. So the deals are hardly risk-free.

MORE: Jamie Dimon's $5 billion bet against bonds

These days, the average loan that goes into a CLO has an interest payment equal to about 4% plus Libor. The AAA portion of a CLO yields around Libor plus 1.3%. That means with the same amount of capital a bank can get investment that essentially pays a 6.5% return instead of 4%. They will have to pay some money to borrow the additional funds, but big banks can borrow pretty cheaply.

Recently, a number of regulators have gotten worried about the amount of credit banks are extending to lower-rated companies. In April, the Federal Deposit Insurance Corp., which assesses an insurance fee on all banks based on size and risk, passed a rule that would force banks to pay a higher premium based on their CLO holdings. CLO managers and bankers say that has slowed the buying by some banks. Other banks have started buying lower-rated portions of the CLOs in order to boost their yield to make up for the added insurance payments. Recently regulators have proposed new rules that would require banks to hold a minimum amount of capital against all their investments, no matter if it's say a leveraged loan or a CLO. Bankers have called the additional capital rule unnecessary and said it would discourage lending.

"The game for banks is always get the returns with as little skin in the game and as much leverage as possible," says Anat Admati, a professor at Stanford's Graduate School of Business, who has written a book called The Banker's New Clothes and pushed for high capital requirements. "This is one of the many ways to play the game."

Join the Conversation
About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

Email | @stephengandel | RSS
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.