On Feb. 4, Moody's Investors Service revised the methodology it uses to rate CLOs, spurring a rash of CLO downgrades that has yet to end. As a result, CLO managers have begun requesting amendments to their reinvestment periods to relieve the pressure, sources said.
CLO managers are increasingly looking to amend their indentures so that they can access returns made from a tranche before it is downgraded, then reinvest those gains in a better-performing asset. Typically, CLO managers are barred from such action until a tranche reaches its reinvestment period. But with so many of their tranches facing downgrades, and with reinvestment periods a long way off, CLO managers have little choice other than to seek these amendments.
Reinvestment periods for older CLOs were between three and five years, while the CLOs launched between 2005 and the first half of 2007 have reinvestment periods between five and seven years.
Amending an indenture is a cumbersome task with many nuances. Typically, the CLO manager goes to the trustee, who consults the investors to get their approval, sources said. Once the trustee obtains approval from investors, the CLO manager goes to the structuring bank, which then goes to the rating agencies to alert them to the amendment. It is, after all, the rating agencies that control which bucket debt will fall into. The banks, sources said, don't like to do this because they don't get paid for it, but they do it anyway to build relationships.
When Moody's revised its rating methodology, the probability that debt at the junior and mezzanine level would default increased by 30%, according to a Wachovia Capital Markets report. This has caused CLO managers to take a haircut. And this means the CLO takes a big hit because most of these assets are trading far from where they were when they were bought.
The revised methodology also affects CLO manager's ability to trade the assets in their portfolios freely. This is because, if a CLO is hit with a wave of downgrades, the CLO is barred from trading assets in the portfolio at their own discretion, according to a Wachovia report. "This will tie their hands even more because discount loan haircuts are impeding managers trading right now," said David Preston, a senior analyst at Wachovia. A main concern for managers, he said, is maintaining coverage tests at par because failing these tests cuts off equity cash flows and manager fees. "Selling loans at a steep loss hurts the par coverage. Because of haircuts on discounted loans, and the fact that so many loans are trading below 80, managers are currently having a difficult time trading because they would have to take the loss twice-once on the loan sold and once on the loan bought."
Furthermore, the new methodology hurts CLOs that hold other CLO paper. This is because those that do hold other CLO paper hold mostly triple-B- and double-B-rated debt. With the revised methodology, some triple-Bs become double-Bs, and some double-Bs become single-Bs or even triple-Cs. For example, a CLO with 5% of its holdings in double-B-rated CLO debt would suffer a 4.5% par loss if that paper were downgraded to triple-C levels, according to Wachovia. This could lead to a scenario where, if double-B-rated CLO paper gets downgraded, it would cause other CLOs to be downgraded.
"CLOs traditionally didn't hold large exposures to other CLOs, but it became much more prevalent in newer deals, especially between 2005 and early 2007," said Gene Phillips, a director at PF2 Securities Evaluations. "The CLOs that are holding 5% or more of other CLOs-typically in triple-B or double-B tranches-are likely to suffer additionally via the triple-C rating-based haircut, as these tranches are downgraded."
Some market participants say Moody's revised its methodology to sharpen its teeth after the controversy surrounding triple-A-rated subprime collateralized debt obligations. And while the problems facing CLOs go beyond ratings, Moody's attempt to get tough has actually exacerbated problems for CLOs, they added. Calls to Moody's were not returned by press time.
Whether or not managers think these changes are good for the market, CLOs in the future will look a lot different than they do now because of them, sources said. They said the mezzanine and junior tranches of today's CLOs will not be included in future deals.
"The complexity that accompanies this leverage-upon-leverage may encourage a market to move toward something simpler," said Phillips, who co-founded PF2, a third-party evaluator of CDO securities, 10 months ago. He was previously at Moody's.
Some firms, such as Citigroup, Morgan Stanley and JPMorgan, are working on CLO structures that have just two tranches, with one tranche all triple-A debt and the other equity. These firms have yet to market any new two-tranche CLOs because the loan market is still frozen. However, once the market thaws, demand for new products will come from a new crop of investors, such as pension funds, sources said.
"Generally, most CLOs in the foreseeable future will be less leveraged and have a senior tranche and an equity tranche," Preston said. "What's happening right now with the ratings revision is cementing something the market had already decided on."
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