Leveraged loans are gaining increased visibility in European CDOs, but a lack of historical recovery data for European leveraged loans has made it difficult in the past to gauge accurate recovery values. Recent transactions are showing higher recovery rates than the indicative ranges previously published by Standard & Poor's, which has prompted the agency to begin the assessment of recovery rates using a loan-by-loan analysis.

"In Europe, these underlying assets do not carry public ratings, so we shadow rate the assets according to jurisdiction," said Juan Carlos Martorell, associate director at S&P. "There is little statistical data from which we can extrapolate levels of recovery. In some cases it may be worth doing a loan-by-loan analysis, especially if the managers think their assets may potentially have higher recovery rates."

To date, most transactions rated by the agency include a weighted average recovery rate test that is calculated by reference to prospective countries and an indicative recovery rate. By conducting the loan-by-loan analysis, S&P would have to look at the individual features of the loans. The recovery framework is based on the manager's track record, willingness, and resources by which to actively recover the loans according to the covenant tests. The manager also has to be willing to fully work out the loan.

But analysts at S&P said the number of inquiries they have received has been fairly limited. It's important to consider that while higher recovery rates mean lower credit enhancements for a CDO transaction, once managers use the detailed analysis they must be able to maintain an ongoing commitment to covenant these higher levels. "We have seen many deals where the manager is happy with the existing expected recovery rates - it's only in those cases where the manager seeks to covenant to higher levels where we are getting the requests," said Martorell.

He added that the evolution of S&P's rating criteria base matches the market's rapid growth in Europe in response to an ever-deteriorating high yield market. According to S&P, the European leveraged loan market started the third quarter with the launch of a E2.5 billion deal that backs Madison Dearborn's LBO of Jefferson Smurfit.

By the end of September, the leveraged loan market recorded E13.2 billion of volume, and the pipeline for CDO transactions of leveraged loans remains robust with an increasing number of players looking to enter the market. These transactions continue to show a strong performance record - no downward action has been taken, nor have any additional D-rated loans materialized in portfolios, noted S&P.

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