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.

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