When the average person hears the words deep discount, a smile is likely to appear. But when a CLO manager hears those words, it can cause them to shiver. That’s because so-called deep-discounted loan substitutions are a huge problem for CLO managers, though some firms and industry organizations have been working to change that by raising awareness on the issue. And they now say they are making progress.

In a market that has seen prices drop dramatically and underlying credit quality deteriorate, CLO managers have been struggling to amend certain indentures that dictate how they manage their CLOs — specifically, how they can swap out deteriorating loans for higher quality, discounted loans. Many of these indentures were written prior to the recession and do not take into account where most loans are trading today.

Since the recession, and since loan prices started to fall, CLO managers have had to deal with these indentures one by one, without any outside help. However, that is changing. Players from across of the market have joined forces in an effort to try to educate market participants about the issue, and more are expected to join.

Amending CLO indentures to allow for deep discount substitutions “reduces the likelihood that a manager will have to make the difficult choice between improving a CLO’s underlying asset portfolio and negatively impacting the CLO’s overcollateralization tests,” said Greg Cioffi, a partner at Seward & Kissel, a New York-based law firm that represents a number of CLO managers, trustees and other market participants. “This dilemma results from the discount obligation provisions in CLO indentures not working as intended in the current loan market.”
However, some investors are not so keen on the change. Resistance to allow these amendments has come from the senior-most note holders in CLOs because they do not understand the complexities surrounding such an amendment, sources said. This is why firms like Seward & Kissel, and industry groups like the Loan Syndications and Trading Association, have begun talking to investors about the matter.

For its part, the Loan Syndications and Trading Association (LSTA) formed a CLO committee several months ago comprised of portfolio managers, attorneys, and others whose objective is, among other things, to encourage market participants to help find a way to ease the negative impact distressed loan prices are having on CLOs.

“Although the approach may vary depending on the relationship between the CLO manager and the senior note holders, it may, in many cases, be productive for a CLO manager to establish an open dialogue with senior note holders to discuss the implications of amending deep discount substitution rules,” Cioffi said.

Amending these deep discount provisions is a complicated task. Prior to the recession, the market value of a loan, for the most part, reflected its credit quality. But as the recession wore on, the technicals of a sour economy began to affect even companies without credit issues. Deep discount loan provisions in CLO indentures require loans to be carried at their purchase price rather than at par when calculating the numerator of the CLO’s OC tests. Because most loans, even from strong companies, have been trading well below par, CLO managers are forced to take a loss on loans that would be worth much more if valued at par.

This is why the LSTA issued an advisory urging loan buyers and sellers to look beyond price as the deciding factor in determining whether a loan should trade as distressed.

While price averages have come back up some from their unprecedented lows earlier this year, the average loan is still trading at a point (in the low to mid-80s) where CLO managers are taking a hit.

In addition to receiving the approval from senior-most lenders to amend their indentures, a CLO manager also has to get approved from the rating agency that rated the transaction so that the amendment does not result in a downgrade or a withdrawal, which would put further pressure on a CLO’s OC test. But unlike the senior-most lenders, CLO managers have not met with resistance from the rating agencies.

Moody’s Investors Service has laid out a number of recommendations for CLO managers to follow when pursuing an amendment. The first recommendation is to provide safeguards to ensure that the credit quality of the portfolio is maintained or improved. The second is for the CLO manager to set a floor value as a percent of par for the substitute assets. And the third is to make sure the CLO manager provides certain limits on the aggregate principal amount of such substitutions. If CLO managers follow these recommendations, it will help mitigate the risk of managers manipulating the par value of the CLO portfolio to improve the CLO’s OC test at the expense of the underlying credit quality, so if CLO managers follow these recommendations, their amendments will likely be approved by the rating agencies.

Despite the obstacles CLO managers face, some have found ways to get these indentures amended. Specific examples are hard to come by due to variety of factors, including the interests of the parties involved and the specific terms of indenture.

However, “A number of amendments to allow for deep discounts substitutions have become effective in recent months,” said Cioffi.

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