The recent spat of corporate bankruptcies and downgrades continues taking its toll on the CDO market, more recently the CLO variety, both the old-fashioned cashflow structures of the late-90s and the currently popular synthetic balance-sheet and arbitrage deals, sources said.

Two cashflow, balance-sheet CLOs recently began early amortizations after triggering diversity covenants, and there may be more in the wings, especially since managers likely prefer an early amortization prompted by diversity covenants rather than credit covenants, which would have more dire consequences for the collateral managers, sources argue.

Thus far, diversification triggers resulting in early amortizations have been confined largely to 35 master trust deals, which are cashflow balance-sheet deals issued in the U.S. In addition to the NationsBank CLO Commercial Loan Master Trust and Chase Loan Obligation USA Trust deals, sources said four other master trust deals have begun early amortizations by triggering credit quality covenants. SBC Glacier and KBC Orion, as well as two private transactions, are going down this route.

Asset shortage to blame?

CLO collateral managers seeking assets to meet diversity requirements or otherwise bolster a deal's credit quality are in a jam because currently, there is a shortage of assets, due in part to an anemic primary loan market as well as the rash of deteriorating credit sectors.

Jeffrey Stern, a partner in the structured finance group at Thacher Proffitt & Wood, noted that a federal rule change last November increased capital requirements for lower rated ABS securities, anticipating a component of a current Basel Committee proposal. As a result, he anticipated that U.S. and European banks would realign their balance sheets, consequently freeing up assets.

"You may see an increase in cashflow balance-sheet deals or other minisecuritizations designed to pull assets of the balance sheet," Stern said. "Or you might see more outright loan sales, which would increase the supply of assets for arbitrage deals."

Even so, that may not help collateral managers facing immediate asset shortages, even if - as in more recent CLOs - there is no early amortization provision.

"You don't want the trustee sending out notices saying the collateral manager is blowing the diversity tests," Stern said. "The reputation of the collateral manager is key to not only getting deals done, but to getting better pricing."

Indeed, collateral managers of deals with early amortizations tied to diversification requirements may even count their blessings if a diversification problem triggers the early amortization instead of a default-related covenant, since that latter can take a far greater toll on the collateral manager's reputation.

For example, Belgian bank KBC's Orion arbitrage CLO, issued in 1999, suffered significant losses that reportedly wiped out the BB-rated tranche. KBC sought to do another securitization last fall of investment grade loans. The deal, marketed by CSFB, pooled several billion dollars of U.S. commercial and industrial loans, and proceeded to struggle through the market.

"They paid 700 basis points over Libor for the triple-B notes, and 1000 over Libor for the double-B notes, and they almost didn't sell it," said one investor, adding, "What I think is the most interesting issue on these deals is what are these issuers going to do about them: if they let the deals default, then the next time around they won't be able to access the capital markets. But they can't guaranty a return because the Fed will step in and say, This is not a risk transfer, and so there can't be a capital reduction.'"

The same source said that most triple-B rated bank CLO paper currently is trading between 250 and 300 basis points over Libor, while "any other triple-B rated paper would be between 125 and 200 [basis points]. That's saying I don't really want that CLO paper on my books unless I'm getting paid. Every time there's a major credit event like Enron or Kmart, it makes investors more skeptical, since the credit protection was razor thin to begin with and a lot of the big banks hold high concentrations of these names."

Will it end soon?

With the U.S. and European economies seemingly on the mend, the trail of early amortizations and high asset-default levels may be tapering soon. Richard Gugliada, an analyst at Standard & Poor's, said that the CLOs going into early amortization in recent years, including several issued by Japanese banks, appear to be reaching the "tail end." He noted that many of the deals had adopted structures similar to credit card securitizations, even though CLOs have far fewer assets in their pools.

"Because the primary motivation was capital relief, they often pushed the structures too far and did not allow for enough of a credit support cushion to allow for any substantial change in the pool's credit quality," Gugliada said. "So they all ended up in a similar situation: a few downgrades and defaults eat through the extra credit support and they go into early amortization."

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