The "CDO problem" of 2001 - considered to be a largely U.S. phenomenon for most of the year - is expected to become firmly entrenched on European shores in early 2002.

While a record number of downgrades had marked the year as particularly turbulent for CDOs in the U.S., the European market had largely been spared; in fact, the number of upgrades had actually outnumbered downgrades during the second quarter and even the third quarter in European activity. But that trend is about to change, analysts say.

"It is inevitable that the pressure we have seen in the corporate sector will translate to stresses in the underlying collateral of CDOs," said Iain Barbour of Commerzbank Securities, who warns that the downgrades seen to date in the European CDO sector are just the tip of the iceberg'. "For example, the telecom bonds suffered downgrades of between five to six notches and the demise of the airline industry will inevitably translate into losses in the CDOs collateral pool."

In the coming six to nine months, performance of European assets may be under threat due to a deepening recession in both the U.S. and Europe, Barbour added.

To date, Moody's Investors Service has already taken action on the first European CDO, Sirius Finance 2000, and has also downgraded one tranche on Leonardo Synthetic PLC, which is backed solely by aircraft loans. Shortly after the Sept. 11 events, Fitch placed a number of deals with ties to at risk' industries - airline, gaming, lodging, tourism - on ratings watch negative and said that it would be monitoring implications of the recent events going forward.

According to Commerzbank, aircraft ABS and enhanced equipment trust certificates (EETCs) are facing an extreme environment.' The airline industry, plagued by a reduction in demand for seats, increased costs in areas such as insurance and lower asset valuations, will surely lead to thinning available cashflows.

The deals that have been hardest hit are the aircraft transactions, and many deals that were expected to come out in the aftermath of Sept. 11 have now been cancelled or delayed. "There are other sectors, apart from aircraft, where we can expect deterioration, [like] CDOs and whole business deals," said Kim Slawek, head of European securitization at Fitch. "We are closely monitoring deals in the retail or consumer sector which are impacted by a slower economy. For instance, deals with an exposure to tourism, in particular deals which are dependent on U.S. revenue on tourism and disposable income, are being looked at."

Downgrade migration has been higher in certain asset classes such as arbitrage cashflow CBOs and synthetic balance-sheet CLOs during 2001 in comparison to historical levels, according to Moody's 2001 CDO transaction study. In regard to aircraft ABS, Commerzbank believes that while it is unlikely that the sector will experience default, a significant ratings migration in the junior classes of up to six notches for sub-investment grade notes is expected.

With several CDOs containing airline risks, the 10 major airlines that have suffered downgrades are likely to cause rating migration of CDOs supported by such assets.

Are CDOs armored for the worst?

It is important to understand that while Sept. 11 marked an extraordinary event, rating agencies are in the business of incorporating extreme scenarios into their assessment of the credit quality of a transaction. "Whenever we rate a CDO we look at all scenarios starting from no default and we group up to a case where every asset suffers a default," said Henry Tabe, an assistant vice president/analyst at Moody's. "In that range you will have a scenario in which an event such as Sept. 11 would be taken care of. Losses to noteholders under such a scenario would then be weighted by the requisite probability of occurrence. Aggregating probability-weighted losses across all scenarios produces the tranche expected loss on which Moody's bases its ratings."

Nonetheless, shortly after Sept. 11 the European CDO market received its wake-up call. The first European CDO backed by a majority of European assets was under attack. Sirius Finance 2000 PLC inducted European CDOs to the downgrade list.

Up until that point the only CDOs under threat had been those with links to U.S. assets. Dresdner Kleinwort Wasserstein, in its most recent report on European assets, reported: "The downgrade of Sirius is significant; as to our knowledge it is the first time that a CDO with a 100% European pool has been downgraded to deteriorating credit quality."

However, it is crucial to note that the credit events that led to the downgrade began to evolve before Sept. 11. "It should be remembered that although an economic slowdown is predicted, it has not really taken hold in Europe," said Bob Patterson at Morgan Stanley. "Therefore, European deals which have been watchlisted or downgraded due to collateral performance have done badly either because of exceptional circumstances or because they had structural flaws." Such is the case for Sirius, which suffered downgrades as a result of credit events that were occurring prior to Sept. 11.

"In the whole-business sector we have been in close contact with our corporate analysis and there are some industries that we feel are more exposed than others," said Birgit Specht, director and head of asset-backed securities at Dresdner. "Deals like Cruise Ship Finance have shown that if you have one obligor, and the economic environment surrounding them is affected, then the deal becomes vulnerable."

Moody's downgraded the EURO324 million tranche of Cruise Ship Finance II to Baa3 from Baa2. In early September, following the terrorist attacks, both Cruise Ship deals were placed on negative watch.

What's next?

Despite a slight widening in spreads, CDOs have actually been thriving in the current market environment. It is only so-called chunky portfolios', or those with concentrated asset exposure, that will be exposed to downgrades.

Yet, the Basel Committee felt it necessary to address what they believe to be increased risks in lower tranches of securitizations. The latest proposal from the Committee contemplates that holding ABS presents greater risk to investors than holding equivalent corporates. "All empirical evidence points to the contrary," said Commerzbank's Barbour. "While recovery rates may be lower in ABS than at equivalent corporate ratings, default probability is also lower, providing consistent levels of loss probability for ABS and corporates, justifying lower risk weightings at higher ratings."

According to Moody's, approximately 75% of the outstanding rated debt in Europe remains, for the most part, unaffected by the Sept. 11 events and less than 10% has undergone ratings actions or changes in outlook.

Going forward, the ABS issues that appear in the market are expected to be constructed with more conservative credit enhancement structures, and will feature asset pools that are less concentrated in some of the sensitive credit areas.

"In the CLO/CBO sector, depending on whether the pool consists of loans to small and medium-sized companies, it's a static or arbitrage pool, and investors need to be selective," said Dresdner's Specht. "This year we have seen how static pools have been deteriorating and even triple-A tranches have been downgraded, so we expect more of this to occur next year.

Specht adds: "We expect there to be a turnaround in this sector eventually but it is hard to say when this will happen; further, this turnaround really depends of the recession in Europe."

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