The message from overseas is clear: murky waters still cloud Europe's CDO market, which has a strong taste for synthetics.

Seemingly ageless corporate names, such as Enron Corp. and Worldcom Inc., continue to dominate already battered synthetic CDO portfolios, contributing to the number of rating actions seen so far this year, said Standard & Poor's in its recent study aptly titled Corporate Defaults Drive European Synthetic CDO Rating Actions. British Energy PLC and Railtrack PLC were two other high-profile entities continuing to pop up. In fact, these four corporate entities were referenced in 12 to 17 transactions of the 39 synthetic CDO downgrades issued by March 2003.

"Enron and Railtrack defaulted in the same quarter, which concentrated the impact on the affected transactions and goes some way to explaining the severity of certain individual rating actions," said Andrew South, a London-based credit analyst at Standard & Poor's.

The rating agency found that for synthetic CDOs, 15% of all note classes had been downgraded at least once at the end the first quarter 2003. At 38%, fallen angels accounted for the largest chunk of downgrades. Continually poor performance of fallen angels means many of these transactions, which were based on the strength and stability of investment-grade bonds, are now looking more like high yield deals, minus the credit support. In all, by the end of March, 23 transactions had suffered more than one obligor default in their portfolios.

On the other hand, 2003 has shown some signs of stabilizing. The rating agency found that out of 257 synthetic CDO transactions, only 39 have experienced a rating action this year, and just four classes of notes, from four unrelated transactions, have defaulted.

"While suffering more severe rating downgrades than the rest of the ABS market, the performance of CDOs has nonetheless been broadly in line with that of corporates," said South.

Furthermore, a decrease in the relative number of classes affected by rating actions dipped back to pre-2002 levels - roughly 5% of outstanding classes per quarter.

Recoveries levels were lower than expected, especially for some commonly held credits in the CDO market, S&P found. In many cases, recovery values were less than 20%. According to the report, obligor defaults alone do not fully explain the extent of synthetic CDO downgrades in recent years. "Accompanying downward credit migration of non-defaulting corporate entities in CDO reference portfolios also appears to have been severe," South said. "[However,] as the CDO market matures, increased seasoning of CDO transactions reduces their susceptibility to downgrade. Whether the trend of fewer downgrades continues will depend in much greater part on the future performance of corporate and other referenced credits."

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