While the tangible effect of actual losses in CDO portfolios due to the presence of Refco Inc. loan and bond collateral is in large part minimal, perhaps the largest losses to be faced within the CDO market stem from what could trigger a turn in investor confidence.
Lehman Brothers, among the most vocal proponents of this idea, called the Refco situation "the most significant event to hit the cash CDO market since early 2003, when the current rally in tranche valuation started in earnest." According to Lehman analysts Claude Laberge and Lorraine Fan, a trio of bankruptcies in just one month's time - Delta Airlines and Northwest Airlines on Sept. 14 and auto parts maker Delphi on Oct. 8 - will lead to a market perception of increasing default rates and lower recoveries to come, causing wider, more volatile cash CDO spreads.
But the string of bankruptcies also came just prior to the Oct. 17 deadline that marked the turning point to a slew of changes to both corporate and consumer bankruptcy law, and at a time when both CLO and CBO spreads are at or near record tight levels. As Lehman points out, cash CDOs have, in general, remained immune to volatility within the credit markets. In fact, CLO primary issue credit spreads actually tightened during the initial corporate credit downgrades to Ford Motor Co. and General Motors earlier this year.
Standard & Poor's notes that 89 U.S. CDOs have Refco exposure, but of those, 85 have less than a 1% exposure, and none have more than an 1.8% concentration of Refco collateral. Fitch Ratings analyst Marion Silverman said, due to the small concentration, she does not anticipate any ratings actions.
But, according to Moody's Investors Service, there will be some impact on CDO ratings, particularly within CBOs and CLOs. Last week the rating agency identified 87 U.S. CDOs with exposure, 12 of which are CBOs and 75 of which are CLOs; the degree of concentration in the Moody's rated deals range from less than 0.1% to 2.1%, and recoveries are generally expected to be greater for CLOs than for CBOs.
Lehman estimates that the CDO market owns 37%, or $240 million out of Refco's total $648 million outstanding term loans. That collateral is spread across 90 CLOs and 32 collateral managers, for whom the company's B1' (Moody's) and BB-' (S&P) ratings and 200 basis point spreads were attractive diversifiers when they hit the market last August, Lehman stated. Now, the high concentration of Refco collateral across the asset class in general could cause volatility in secondary trading.
While loan obligations stemming from the recently bankrupt Collins & Aikman Corp., Delta, Northwest and Delphi are all current on interest payments and subsequently were trading from $0.94 to $1.02 on the dollar as of Oct. 14, the shock to the market that was Refco could be enough to cause investors to reassess expected recovery rates. As a result, an increasing number of investors may begin to ask for tougher scenario assumptions, slowing the new-issue CLO market and widening CDO spreads. Without significant widening in loan market spreads, the effect could be a substantial drop in arbitrage opportunities, significant in light of what is a relatively high number of CLO transactions in the pipeline, according to Lehman.
Fitch's Silverman said the rating agency is watching about $125 billion worth of bonds issued by BBB' to C' rated companies, however most of those bonds within CDO transactions are within later vintage deals, which are already benefiting from paydowns. And at a time when spreads are so tight within CLO tranches that a record number of managers are requesting weighted average spread amendments just to acquire more collateral, widening spreads might actually prove helpful, she added.
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