With much of the financial industry's higher-rated bank loans already securitized, smaller, lower-rated loans to middle market companies are making up larger concentrations of balance-sheet CLOs, according to recent research by Bank of America Securities.

Though hesitant to call it a trend (as the deal sampling is still too small), ratings analysts confirm that there are several outstanding proposals that include larger portions of lower-rated bank loans, and agree that banks have already mitigated much of their significant risk exposures, which tend to be larger loans to larger, rated entities.

"I think there's a number of things going on," said Jeremy Gluck, co-head of the CDO group at Moody's Investors Service. "Banks have done a lot in the way of hedging via synthetics to remove some of the bigger risks from the balance sheet. And they're probably moving down the scale to the smaller companies that pose lesser risk, but it's still risk."

As an offshoot of this trend, the equity portions of balance-sheet CLOs could become larger, to add subordination to the pools of lower quality credits. However, a pool of smaller loans could include significantly more borrowers, which would add diversity, as the investor would be exposed to a larger pool of credits.

"If you have 500 lowly rated counterparties, compared to 50 highly rated counterparties, it would certainly help toward getting better tranching," said Elwyn Wong, an analyst at Standard & Poor's.

One of the challenges with packaging, or referencing these smaller loans in CDOs, has been assessing risk. Many of the middle market companies, which borrow in the $3 million to $5 million range, are unrated.

Further, many of the loans are collateralized by a specific asset (or assets) which can be difficult to value.

"Unless you actually go kick the tires around a little bit, and actually look at the asset, it's really difficult to be a couple thousand miles away, and figuring out what the actual recovery on this asset is going to be," Wong noted.

In the last year and a half, models such as Moody's RiskCalc, and Portfolio Management Data, which was acquired by S&P last spring, have emerged as the tools for assessing the risk of these loans, which the rating agencies are now relying on. The models add robust statistical analysis to the process, analysts said.

Basel II, pushing the trend

Also, in BofA's report, author Lang Gibson notes that Basel II, the new capital adequacy guidelines proposed by the Bank of International Settlements, would further motivate financial institutions to transfer risk off pools of lower rated assets.

Cited from the report: Contrary to popular myth, the current version of Basel II ... will not take away the attraction of securitizing loans through synthetic CLOs as a form of regulatory capital arbitrage. Instead of higher-rated investment-grade credits dominating the collateral, under the proposed Basel II there will be larger allocations to lower-rated credits.

The proposed guidelines require more capital for riskier, below investment-grade credits, compared to the current guidelines, which don't make as clear a distinction. The current guidelines have motivated banks to sell risk off their more highly rated assets, and hold less capital against them.

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