JPMorgan's early amortization of one of its CLOs is yet another sign that diversity scores are becoming more and more of an issue for managers when loans are prepaid or downgraded and can't be replaced so easily in the collateral pool. The banks' Chase Loan Obligation USA Trust (Clout) 2000-1A is the second CLO in a month to begin early amortization after tripping its diversity trigger.
The $1.05 billion Clout deal comprises a triple-A rated tranche making up 90% of the issue, with another 5% comprising an A-/A3 rated tranche and the remainder an unrated subordinated piece. Although the original ratings on the transaction remained the same as of press time, one investor said last week that his institution had sold its exposure to the single-A-minus piece on mounting concerns about the fate of the subordinated portion.
"We did an analysis and more than half the subordinated tranche had already been written off by defaults, and we were concerned we could lose the rest of that tranche and begin to take losses on the A- piece," the investor said.
The investor noted that his institution expressly avoids distressed paper, and so takes a conservative view when faced with negative developments.
At the beginning of the month the triple-A piece was offered in the secondary market at 99-30, with three years of average life remaining. The triple-As were issued at Libor plus 27. One investor said he bought the bonds three weeks ago, anticipating an early amortization event. S&P does not consider failing a diversity test a credit event, but more of a technical breach of the indenture
John Coffey, managing director in JPMorgan's credit portfolio group, said the Clout transaction has indeed experienced defaults totaling $29.6 million - 2.8% of the total deal - to which the $52.5 million subordinated portion has first exposure. However, he cautioned, those defaulted assets do not represent the eventual losses. "Most of those assets trade in the secondary market and have prices over 50 cents on the dollar," Coffey said "One loan doesn't trade, but it's backed up by a piece of real estate. Even if we only recover 50% [of the assets' value], that's a $14.8 million recovery.
"So when you look at pure defaults, the number might look like a lot has been eaten up, but you have to look at recoveries," he added.
Nevertheless, that may represent a significant hit to the counter-parties in the credit default swap, since they now hold the exposure to the subordinated assets. But investors higher up the credit ladder have less to be concerned about than the default rate might indicate. Coffey added that Clout carries a default covenant that has yet to be tripped, and that the default rate would have to nearly double, to $52.5 million, to activate that covenant.
Coffey also noted that $4.5 million in excess cash, generated from the spread between return on the assets and payment on the bonds, has been accumulated since the first loan default in April 2001. "That money is used to buy more loans, which creates more assets and collateral for the senior pieces," he said.
The investor noted that in light of having less equity and more leverage, the investment-grade pieces "seem to be taking the hardest hits" over the last six months. He said another investment-grade deal from a U.S. bank, this one managed by a third party, has also run into some asset troubles.
Concerns are natural
Investors' concerns, however, are bound to be greater in a loan environment where the default rate is anticipated to average 7% this year, although that's down from close to 9% in 2001.
"I think a lot of investors are concerned about whether their assets are going to get downgraded. The ratings agencies haven't changed the rating [on Clout], and while I'm sure they're looking at it, we have a ways to go before that middle slice is imperiled," Coffey said.
While the Clout deal's rating may remain unchanged, the transaction did begin amortizing early in March, following the triggering of a diversity covenant. Coffey explained that finding replacements for downgraded or prepaid assets inside a CLO can be challenging, especially when less than a year remains until the transaction matures. In this case, JP Morgan Chase, acting as manager, was faced with choosing either to re-jigger the deal's terms - an arduous task - or to follow the deal contract and begin early amortization.
"We said Why should we put everybody through that? Wouldn't it be better to just pay the notes back?' So we went to the three agencies and they hinted to us that the best way to protect the deal's rating was to let it run its normal course," Coffey said.