According to some analysts investment grade (IG) average CDOs (as well as other credit products) could be vulnerable to a corporate spread blow out and exposure to the airline and insurance industries. The IG CDO vulnerability to airline and insurance exposure is similar to other deals, but what is unique is the very thin amount of equity (about 3%) supporting these transactions and the possibility of large industry and industry-related exposure that is moderately capped by the rating agencies.
Below is a comment from Lang Gibson, head of structured credit products research at Banc of America, giving his thoughts on potential effects on existing IG CDOs as a result of the widening corporate spreads:
In a traditional cash IG CBO, spread gapping -- even in the absence of defaults -- can have negative ramifications, particularly for subordinated tranches. As spreads in the underlying collateral gap, the first impact is normally felt on the weighted average rating factor (WARF) tests and the rating bucket tests. Then, as it becomes clearer these tests may result in a downgrade to the rated tranches, the manager may begin trading out of losses. It is at this point that overcollaterization (O/C) and Interest Coverage (I/C) can be breached.
The stringent cash CDO tests direct the waterfall - i.e., allow principal to be paid to senior tranches at the exclusion of junior tranches - and impact the rating migration of the rated notes. Therefore, even in the absence of defaults, CDO are vulnerable to temporary spread gapping as occurred during the 1998 spread contagion period. However, the more senior tranches, of course, benefit from the waterfall rules. The key drivers of CDO performance in the absence of defaults is the amount of spread gapping and the length of time before spreads return to more normal levels. /IFR Asset-Backed Securities
