While much of the structured finance market in Europe was badly affected by contagion from the subprime problem in the U.S. and the ensuing liquidity crunch, leveraged super senior (LSS) CDOs - a little-known facet of the European collateralized debt obligation marketplace - seem to have held their ground. And experts believe that this market can continue to hold its own because of the structure of LSS deals.
LSS transactions gained prominence in 2005 as a result of the downgrades of Ford Motor Co. and General Motors, when hedging in the super senior space became attractive to dealers. LSS deals, in essence, provide investors with leveraged exposure to the super senior portion of a CDO capital structure. Through leverage, super senior tranches achieve spreads that are typically five to 10 times higher than those of an unleveraged senior triple-A tranche. Indeed, when LSS CDOs were first printed in Europe, many investors benefited from spreads in excess of 100 basis points for triple-A risk, said David Littlewood, a principal at London-based structured finance and investment firm Cairn Capital.
Recently, dealers have shown interest again in using LSS CDOs to hedge the senior part of the capital structure due to spread and correlation movements over the summer, said Jeffery Cromartie, a director at Derivative Fitch in London, which has just put out a report on LSS transactions in Europe. But whether the market will actually see more of these deals remains in question, as investors, for the most part, are still reluctant to get involved in anything new after the August market scare.
"In August, banks were quick to put out new LSS structures through their sales forces, but it is unlikely that many buy-and-hold investors bought these products on the basis that they were probably focused on market-to-market issues and risk across the rest of their portfolios," Littlewood said.
But even if investors remain risk-averse after the summer scare, those who know LSS deals maintain that their structure stands them in good stead. Derivative Fitch, in its analysis, took a look at how much stress an LSS deal can withstand before it gets into distress, and the results were positive.
"Each of the three primary trigger structures has performed within Fitch's expectations," the agency wrote in its report. "All European LSS transactions continue to have cushion above the unwind trigger levels. In addition, the ratings assigned to these transactions continue to exhibit moderate cushion levels."
The European LSS deal's forte is its structure. Unlike, for instance, transactions in the huge Canadian LSS market, European LSS deals have been financed by buy-and-hold investors, who fund for the term of the product unless a deleveraging event takes place, Littlewood said. As such, during the market fallout these deals did not suffer like Canadian deals, which were financed through short-term, commercial paper-backed conduits and were therefore impacted like any other product linked to the commercial paper market.
"In Europe the vast majority of LSS deals have deleveraging triggers linked to loss or spread rather than market value, whereas in the Canadian market the LSS deals have market value triggers," Littlewood said. "There has been massive spread widening recently but no investment-grade corporate credit losses. In some Canadian transactions, this may have caused deleverage triggers to be hit, which would have compounded the CP market issues. But it has not been severe enough to trip spread triggers on European deals. Similarly, loss triggers have not been hit on European deals either."
Littlewood believes that timing has also played a part: Most of the European LSS transactions were done in the summer and autumn of 2005, whereas deals were still being done in the Canadian market up to the end of 2006. "European deals have therefore benefited from the effective subordination created through rapid time decay," he said.
Looking ahead, one challenge that Cromartie cites for weighted-average rating factor (WARF) trigger LSS transactions is their significant exposure to structured finance CDOs, many of which are backed by poorly performing U.S. subprime RMBS.
"Given the negative outlook in the U.S. RMBS sector, structured finance CDOs are likely to continue to remain under rating pressure," the Derivative Fitch report states. "In light of these circumstances, Fitch will continue to carefully monitor these structures for any sign of negative performance stemming from underlying structured finance CDOs."
The WARF trigger LSS transactions can withstand between 8% and 30% of the underlying CDOs, suffering six notch downgrades before the current LSS rating cushion is exhausted, Cromartie said.
In Europe, Fitch has rated 20 LSS transactions with a total volume of $944 million. Eleven transactions are still outstanding, while nine have been dissolved by the mutual agreement of each party, the report states.
None of these transactions were called due to a trigger breach, and all called transactions were performing within expectations when they were called.
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