FleetBoston Financial Corp.'s Ark CLO I, a first-of-its-kind all distressed debt collateralized loan obligation, continues turning heads in all different sectors of the financial markets, according to ratings agency sources, and the banks involved.

Standard & Poor's Ratings Services has been approached by a combination of players: be it other large banks looking to shed exposure, distressed debt fund managers, hedge funds, or general, happy-go-lucky arbitrage opportunists.

"I think we'll clearly see more distressed debt transactions," said David Tesher, a managing director in the CBO/CLO group at S&P. "[The FleetBoston] transaction alone, with the publicity that it has received, has facilitated many inquiries."

Although different types of market players have shown interest in replicating the distressed debt CLO, those who have seen the transaction up close said the structure is most applicable to banks or insurance companies with large portfolios of distressed bank loans.

Apparently, Patriarch Partners, the collateral manager on the deal, is likely to be structuring similar trades with other banks going forward, although an official at FleetBoston said Patriarch is under certain capacity restrictions, and will need to "get this one up and going" before structuring the next one.

In FleetBoston's case, the loans came from the balance sheet, where there was a sufficiently large portfolio of loans to select from. A regular distressed debt fund manager may not have selection perspective to create a large enough, or diverse enough pool to fit the criteria required for a distressed debt deal, S&P's Tesher said.

Deal Structure

FleetBoston's transaction was worth just over $1 billion. Essentially, the bank outsourced the workout function on the portfolio of distressed loans to the collateral manager, Patriarch Partners. According to reports, the merger of Fleet Bank with Bank Boston and Sanwa Business Credit created overlapping concentrations of loans, which spurred the transaction, thereby removing the loans from FleetBoston's balance sheet.

The transaction was structurally complex, including a $100 million triple-A rated revolving senior tranche wrapped by Financial Security Assurance. The revolving piece was co-purchased by several conduits acting, in part, as liquidity providers. The triple-A's sold for roughly 50 basis points over Libor.

"We were delighted with Patriarch," said one content holder of the bonds. "The wrapped, 1.7-year WAL, triple-A tranche, which had a robust structure, made this deal one of the best values of 2000."

There were two $412.5 million A-class term notes, both rated triple-A, and a $75.75 million B-class tranche, rated single-A. The transaction also included a $35 million equity piece. CIBC World Markets underwrote the deal.

Challenges

One of the challenges in structuring the transaction was adjusting the established CLO model to a distressed one, which is to modify the waterfalls to take into account the "dynamics of the distressed assets," said Kenneth Wormser, managing director and global securitization head at CIBC. "At some point [the assets] go through restructuring; i.e. they don't pay interest, there's a higher probability of default, and you go through all the different stresses, which are fairly different than in a normal CLO."

CIBC is currently in discussions with other banks looking to replicate the Ark deal. Although Wormser would not name the banks, he did agree with S&P's Tesher, in that the structure is most applicable to players with large portfolios of below investment-grade bank loans.

Some of those are Bank of America, Wachovia Securities, and First Union, all candidates for distressed loans CLOs, another source said.

From S&P's perspective, the analysis on a distressed debt CDO is more in line with a severity analysis as opposed to a default frequency analysis, Tesher said.

"We're assuming the bulk of the portfolio defaults, and then we're focusing our analysis on severity and liquidity, and looking at cash flow stress scenarios, including different timing of loss and recoveries," Tesher said.

Liquidity requirements play a large part in the credit analysis of a CLO backed by distressed assets. The reasoning is that, assuming a large percentage of defaults, there needs to be a structure in place providing cash flow during workout. The liquidity can come in various forms, including funded cash reserves up front, or an external highly rated liquidity provider to provide liquidity support, Tesher said.

"In addition to testing for return of bondholder principal, we test to ensure that there is sufficient liquidity in place to pay timely interest for the various rating levels we extend," Tesher said.

In the case of Ark CLO I, up-front cash reserves were used to provide liquidity, in addition to the conduits, which provided senior-note funding, a source said.

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