The practice of "notching" adjusting ratings, or refusing to rate, certain asset pools in a structured product unless a substantial portion of the assets are rated by the same agency rating the structured product has been a controversial issue for the wider debt markets for some years now.

But the syndication of two recently launched bank-loan deals for Resolution Specialty Materials (RSM) and Ripplewood Phosphorus brought the topic back into the spotlight. Some collateralized loan obligation managers missed out on the action, not because the loans weren't attractive enough, but because Moody's Investors Service had not yet rated the underlying collateral.

"Complications associated with having non-Moody's rated loans in a Moody's rated CLO made it tough for some CLO managers to invest in the two deals," a CLO investor said.

This scenario sheds light on investment issues portfolio managers can face when dealing with certain ratings agency-inflicted restrictions in their CLOs. Of course, rules and restrictions are required to properly assess risk in a CLO, but some investors argue that the main ratings agencies, Moody's, Standard & Poor's and Fitch Ratings, sometimes implement rules that are problematic for CLOs. "It doesn't matter which of the three [agencies] it is, you have the same kinds of challenges," said Howard Tiffen, senior portfolio manager at Van Kampen Investments.

In the cases for RSM and Ripplewood, both credits were rated single-B plus by S&P, sources said. But the lack of a Moody's rating the agency is waiting on audited financials before it releases bank loan ratings for the two credits, sources said could force a CLO investor to use the S&P rating and notch it down twice to achieve the equivalent Moody's rating. If notched down twice, RSM's and Ripplewood's Moody's ratings would be B3,' much too speculative for some investors' appetites. That's because due to a CLO's weighted-average rating factor test, the lower rating make the deals increasingly unappealing to a CLO investor. "It's not so much that I can't buy an unrated deal, but notching it down makes the loan unattractive," an investor said.

A Moody's spokesperson said the agency, "believe[s this article] is based on one specific situation that should be handled between ourselves and the concerned party and [Moody's is] not willing to engage in a public discussion of confidential information." Yet investors disagree.

Some CLO investors still say they are limited in how many unrated or single agency-rated loans they can invest in because of "notching buckets" included in CLOs.

In fact, some investors said the rating agencies' increase in requiring certain CLO tests, despite efforts to improve efficiency on the part of the agencies, has caused frustration for loan investment managers because of incongruities in the system.

For example, one investor said he must apply the Moody's senior implied ratings of companies that his Moody's-rated CLO invests in for rating and recovery tests. But inconsistencies can occur when the senior implied rating is only at the holding company level, while the loan investor is investing at the operating company level. "We're right at the operating company level, which is a good spot to be as a senior secured lender... [And] even though the loan might be at Ba3,' we get no credit for that since the senior implied is B1'," he said.

In response, Moody's said that, "While the senior implied rating is used for the WARF, the higher facility rating will result in a higher recovery rate for the recovery rate test."

S&P, too, has confronted this sort of situation because it applies its issuer credit rating for CLO tests, instead of the direct loan rating.

Issues, such as the senior implied example, can eventually get wrung out of the system as the agencies continue to respond to problematic situations, Tiffen said. "There are still inconsistencies, but they are few and far between compared with five years ago," he said. Every situation is different for each CLO manager, and experience usually makes dealing with issues surrounding CLOs easier, he said, adding, "More experienced managers know how to figure these things out... Over time, you become more well versed in the mechanics and compliance issues."

All the same, a one-notch rating difference can still be a big concern for CLO investors. "Small changes, loan to loan, make a big difference in a CLO," said John Connor, a vice president in Hartford Investment Management's bank loan portfolio management team, which manages several CLOs. For example, a rating just one notch lower than single-B plus could make a CLO manager unable to invest in a deal because of its effect on the CLO's ratings test, he said.

To be sure, the ratings agencies' ratings methodologies do not go without justification. Moody's policy on notching is to minimize a Moody's-rated CDO's reliance on notched ratings, according to a special report written by managing director Jeremy Gluck in December on how Moody's deals with non-Moody's-rated collateral instruments in Moody's-rated collateralized debt obligations (CDOs). "Reflecting the philosophical and analytical support for minimizing reliance on notched ratings, Moody's has generally been comfortable with no more than a 20% notched bucket within multisector CDOs," Gluck said. Non-Moody's rated collateral in a product could even be unlimited, depending on certain factors, he said.

Still, "For some asset classes, including CDOs themselves, [Moody's has] concluded that the divergence in ratings is simply too great to contemplate notching," he said. Performing ratings estimates, also known as "shadow ratings," is Moody's' preference for dealing with non-Moody's rated collateral. Shadow ratings are offered at the extra financial cost of a CLO manager or issuer.

S&P prefers to supply credit estimates for non-S&P-rated loans. "Leverage-loan securitizations generally require credit estimates for unrated assets," said David Tesher, an S&P analyst, in response to S&P's policy on non-S&P-rated collateral in CLOs. "S&P's Risk Solutions group performs estimates for such obligors using its Credit Model and other probability of default models.... Our main goal is to understand the corresponding credit risk that a prospective issuer looks to incorporate into their structure," he said.

Fitch, on the other hand, appears to have a more flexible approach to accepting non-Fitch rated collateral. "If there is a large (two, three or more notch) discrepancy between S&P and Moody's ratings, we may take the lower of the two; if there is a split rating between investment grade and non-investment grade, we may take the lower of the two; or if we have a distinctly different opinion on a credit or sector, we may provide a private rating," said Jill Zelter, a managing director in Fitch's credit products group.

Fitch, however will accept just one Moody's or S&P rating, if only one is available. She said this methodology, which accepts the other agency ratings, is based on a past Fitch study, which concluded that its ratings usually fall in between S&P's and Moody's. "We have no mandatory minimum requirement for Fitch-rated collateral. However, if a public rating is not available, Fitch would provide a private rating for the loan," she said.

All the same, Fitch almost has to allow Moody's and S&P ratings because of the hold the two have on the loan ratings market, one investor said. "There's no way I could get a deal done without using Moody's and S&P," he said. "They've become the de facto

standard."

Ultimately, despite investor discrepancies regarding the two agencies' dominance in the loan ratings space, CLO managers said the issues they face in arranging their CLOs with the agencies are, for the most part, manageable. "In the positive environment we are in now, [notching] is not much of an issue... But when collateral becomes really stressed, then it becomes a real issue," said Tiffen.

"You work around it," an investor said. "If the ratings agencies maintain consistency and are open to suggestions when structuring CLOs, then CLO managers can deal with the investment restrictions."

"It all depends on how strong your dialogue is with the agencies," added Tiffen.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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