The CDO market has witnessed increased downgrades in 2001 as structures have absorbed defaults in the collateral markets. Concern has been raised that weakness in the market value of CDO collateral may pose additional independent risks to investors beyond the reduced cash flows caused by defaulted assets. Some have suggested a market value subordination measure as a way to assess this risk. This concern is misplaced. While collateral market value is relevant as one means to estimate probability of default, the market value of a CDO's assets will not trigger any type of CDO event. Collateral market value affects a CBO directly only when the collateral is subject to liquidation, a situation that is extraordinarily unlikely and only occurs subsequent to a CDO event of default. It is useful to review what events of default are... and aren't, and how the CDO collateral is handled if an event of default occurs.
The term "event of default" has a ring of finality to it. One has the sense that the game is up and the interested parties must convene to divide up the assets of the issuer. While it is true that an event of default is always serious, it does not necessarily lead to a collapse of the CDO. Events of default can be cured. If a cure is not possible, then the event of default prepares the way for noteholders to decide how the assets of the CDO should be handled. Senior noteholders generally have more control as would be expected because of their senior claim to the collateral.
CDOs are designed to allow for noteholders to quickly and efficiently take action when an event of default occurs. This contrasts with events of default in the corporate market where the bankruptcy courts are most often involved. Corporate workouts are quite time consuming, often taking months or years to complete. In a CDO all matters proceed by way of notices and votes. Here a caveat is in order. It is important for noteholders to make sure proper communication channels exist between the trustee and the investment management group. Most documents provide for fax notification but these details are often overlooked in the closing process. There have been situations where votes have been unnecessarily delayed for extended periods of time because the required noteholders were not able to respond in a timely fashion.
Operational events of default
Events of default can be divided into two basic categories, operational and performance related. Operational events of default occur when the issuer is unable to operate in accord with duties as set forth in the indenture and where this inability materially affects the interests of any of the noteholders. Operational events of default are unrelated to deal performance but are often curable. Typical operational events of default include the failure to apply funds when the funds are available, breaches in representations made by either the issuer or collateral manager, adjudications of bankruptcy against the issuer or the loss of an issuer's favorable status. Generally the issuer is put on notice of an operational event of default and is given a reasonable amount of time to fix the problem. In the case of the payment of funds this will be a number of days and in the case of a structural or legal problem, a month or two. Operational events of default are not unique to CDOs. They exist in other markets as well.
Performance related events of default
Performance related events of default arise when insufficient funds are available to meet a mandatory interest or principal payment or when certain performance related triggers are breached. For example, noteholders are often given the right to replace the collateral manager in the event the par coverage drops below a threshold level.
This "manager event of default" was first used in insured structures to provide the insurer a right to immediately step in and take control of the collateral without having to allege misconduct or negligence on the part of the collateral manager. This right was included as an event of default because it mandated a change in control over the collateral. A manager event of default is curable. The specified noteholders, typically 66-2/3% of the senior most classes or the insurer, can appoint a new collateral manager. This will cure the default. If the manager is not replaced, the event of default continues but should not affect the CDO in any other way. A manager event of default will only occur, however, if there has been substantial par coverage erosion so while the event of default does not trigger any specific action it is evidence of an unhealthy deal.
Failure to make a required payment to a tranche is the most serious event of default. Prior to the final maturity date, a payment event of default would occur only when there is not enough cash to pay the senior most classes of notes outstanding, swap payments and issuer expenses.
This is a critical point. Even in a situation where a deal has suffered a substantial reduction in par coverage and is unable to make interest payments to some of the noteholders, a payment event of default is not triggered. It is important to differentiate between current-pay tranches and those whose interest is paid only when available ( pay-in-kind "PIK"). PIKable tranches may be investment grade but a failure to pay their interest prior to maturity is not an event of default. While a payment event of default is serious it is also extremely unlikely.
How many collateraldefaults can a CBO sustain ?
It is difficult to conceive of a realistic collateral default scenario where a CDO would be forced into an event of default prior to its stated maturity. A typical CDO could withstand 10% annual defaults without triggering an event of default. At 15% annual defaults, the CDO would itself default after 10.5 years, only 1.5 years prior to its stated maturity. The historical average for high yield defaults is 3% and the worst single year on record, 1990 sustained 7% defaults. The critical point to be drawn from this data is the remoteness of an event that would subject the CDO to a forced sale of assets. While overall CDO performance, particularly for tranches below triple-A, would suffer with default levels below those that drive a deal into default but the CDO would not be forced to sell collateral into a weak credit market. This is the essential benefit provided by a CDO's non-recourse structure.
Acceleration and liquidation
In the unlikely scenario of an event of default, whether it be operational or performance related, the notes are generally accelerated making them legally due and payable. It is as if the final maturity date has come. Notes can be accelerated in three ways.
First, the trustee can declare an acceleration with the consent of a percentage of the senior noteholders, or if an insured deal, the insurer. This class of noteholders is often referred to as the requisite class and is generally a 66-2/3% majority of the senior noteholders. Second, the requisite noteholders can themselves direct an acceleration and third, in some events of default, typically those caused by a court's declaration that the issuer is bankrupt, the notes are accelerated automatically.
Liquidation is an option for noteholders only after an acceleration. For all events of default except for a payment event of default the consent of 100% of the noteholders is required. If the event of default is caused by a payment failure then the requisite noteholders alone may vote to liquidate, a vote that still requires 66 2/3rds of the senior most classes to agree.
Performance depends upon collateral credit defaults
A forced sale of CDO collateral arises only when a deal suffers a payment event of default. Additionally, it will not occur unless the requisite noteholders affirmatively so vote. Given the severity of collateral defaults required to trigger an event of default this risk can safely be called remote.
The assets of the CDO remain non-recourse. It is for this reason that valuation methodologies based upon market value subordination are not terribly useful. In practice, for cash flow CDOs, collateral credit events remain the primary factor affecting actual performance. The collateral manager event of default will never give rise to a portfolio liquidation but will give requisite noteholders the opportunity to efficiently direct a change of manager.