"No matter how cynical you get, it is impossible to keep up." -Lily Tomlin.

So went the year 2008 in the middle-market (MM) CLO space: each time prognosticators predicted that the bottom was near, conditions took a turn for the worse and the MM CLO market sank deeper still. MM CLO issuance, significantly down in the latter half of 2007, all but completely dried up in 2008.

Warehoused Loans: Sit Back and Stay Awhile

The drop-off in MM CLO issuance has led many funds, business development companies and specialty finance companies in the middle-market lending space to rely more heavily on asset-backed commercial paper funded warehouse facilities and structured loans to special purpose entities as primary sources of financing, rather than as temporary parking spots for assets destined to be packaged and sold into a CLO. However, warehouse providers continue to face liquidity issues and have become increasingly concerned with preserving their balance sheets, making it more and more difficult for all but the tier one originators and managers to access this much needed warehouse funding (even when renewing existing facilities), and then only at the cost of steep fees and significantly increased pricing.

The hostile secondary market for MM loans will undoubtedly continue to discourage lenders from opening new warehouse lines, but may in fact work in favor of managers seeking to renew existing facilities. The portfolio for a warehouse facility that is up for renewal will likely include many older vintage loans with lower than current market interest rates. Where renewal terms include significantly higher pricing, lower advance rates and hefty fees, the manager may conclude from a cost/benefit standpoint that it should terminate the facility and forfeit the collateral. Since most warehouse providers cringe at the prospect of foreclosing on an illiquid pool of loan assets, a manager willing to walk away from the collateral in a non-recourse securitized credit facility possesses a valuable bargaining chip.

Even more valuable to a manager in this new age of restricted access to credit will be its relationships with warehouse providers. According to one leading manager in the MM CLO space, David Golub of Golub Capital, "While we would all prefer to be doing business the way we did pre-August 2007, we live in a market today where it is critical for managers to understand the limitations of their bank groups and be proactive in proposing solutions that are win-win for all involved. At the end of the day, strong relationships survive tough times."

Interesting developments to look out for in 2009 would be those initiated by the federal government. Middle-market loan originators and managers provide and service credit for many small businesses, the success of which has been widely acknowledged as critical to restoring economic stability. There are many in the middle market space that have wondered aloud why the Troubled Asset Relief Program (TARP) and other government funding has not been made available to middle-market commercial finance companies. A less drastic step, along these same lines, would be to expand the Term Asset-Backed Securities Loan Facility (TALF) to include purchases of middle market CLO 'AAA' tranches as a means to restore liquidity to the middle market space. Continuing bailout efforts in 2009 may impact the availability and terms of financing to MM loan originators and managers.

The Law of Unintended Consequences

Terms and triggers aimed at protecting investors which were placed into CLOs during a credit friendly times have had unintended consequences as the market has deteriorated. For example, many CLOs give credit to discount securities (loans and securities purchased below 80% or 85% of par) for purposes of overcollateralization tests based on market value rather than par in order to account for the lower credit quality assumed to be typical of these assets (or, as Moody's Investors Service published criteria states, to avoid allowing CLO managers to "manufacture par"). However, it is not unusual in the current environment for secondary market prices of relatively high quality assets to be around 80% or 85% of par. The negative treatment of discount securities in CLO documents inhibits the ability of managers to take actions beneficial to their deals, that is, purchasing good assets for low prices - a result which, ironically, stems from a mechanism originally thought to protect noteholders.

Limitations on distressed exchanges and other loan restructurings have also created a quandary for managers. Some CLO documents treat a loan as defaulted when the loan becomes subject to a restructuring or amendment which has been effected for the purpose of preventing the loan issuer/obligor from avoiding a default. Additionally, many CLOs require noteholder consent prior to the manager's consent to any loan modification which reduces principal or subordinates senior creditors. Such treatment reflects the assumption that restructurings would only be necessary for seriously deteriorating loans, which assumption may have had more practical application at a time where unmodified performing loans available were plentiful and available to the manager in the market. In today's economic climate however, distressed exchanges, restructurings, amendments, waivers and other work outs are becoming increasingly commonplace in the face of the liquidity strains felt across all industries. In many cases, amendments and restructurings may be necessary to avoid payment defaults and further deterioration of assets, yet managers have a disincentive to work out loans included in their CLO portfolios.

Finally, the 'CCC+'/'Caa1' bucket has presented what is probably the most significant unanticipated challenge. Most rated MM CLOs have a limit on loans rated 'CCC+'/'Caa1' or lower such that the balance of these loans which exceeds of a specified percentage of the total portfolio balance will be haircut (i.e. treated at less than par) for purposes of determining overcollateralization and other tests for the deal. This feature was designed to prevent the manager from purchasing too many low rated loans into the CLO and to encourage the manager to sell loans that have been downgraded before they further deteriorate in credit quality. Loan downgrades are now on the rise and managers must sell assets at or below the 'CCC+'/'Caa1' threshold in order to maintain test compliance. However, since the current pricing in the secondary market for loans of these ratings is often insufficient to allow the manager to reinvest in replacement collateral, holding on to these assets would likely provide for a greater overall recovery for Noteholders if only this were an option.

Shotgun Weddings: Collateral Manager M&A

These dramatic changes and pitfalls in the MM CLO market, as painful as they are, may be part of the overall process of market correction and reform necessary to restore discipline and confidence to the credit markets, however, in 2009 we expect that too much "discipline" will push a number of companies out of the middle-market loan space altogether.

In 2008, we saw how the current environment has led to an increase in consolidation and re-alignment among CLO managers. Some of the stronger managers have taken advantage of opportunities to pick off management contracts from institutions which have decided to exit the CLO management business and/or to expand their market share by swallowing up shakier competitors at bargain prices. We expect this trend to continue into 2009.

CLO manager consolidations may take a variety of forms and structures. In 2008, the three basic structures employed were sub-management contract, outright contract assignment and traditional corporate merger/acquisition. Looking forward to 2009, we expect that changes in market conditions will impact the popularity of each structure. The sub-management arrangement, for example, which delegates some or all of the rights and duties of the original manager to a sub-manager and leaves primarily liability with the original manager, creates an ongoing relationship between the parties. If market conditions continue to deteriorate into 2009, we would expect to see more managers opting for acquisition structures that offer a more permanent exit from the market for the failing acquired manager. An outright assignment of CLO management agreements from old manager to new provides such a permanent alternative but generally requires CLO noteholder consent, which may be costly if not impossible to obtain. Therefore, we predict the third structure, corporate M&A, will have a boost in popularity in 2009 and we expect to see a variety of new creative merger and equity purchase transactions.

Conclusion

Notwithstanding the above challenges, MM CLOs continue to perform relatively well, particularly compared other types of CLOs and CDOs. In 2008, there were a few downgrades of MM CLOs, yet most deals continue to avoid downgrade and make timely payments of interest and principal. While any predictions for 2009 are inherently uncertain given the present volatility, it seems fairly certain that loan defaults will continue to rise in 2009 before leveling off, with new MM CLO issuance volume staying at very low levels and most activity in the MM space to come from restructuring of existing CLOs and warehouses and collateral manager M&A. However, once loan default levels peak and begin to subside - most likely towards the end of 2009 - investors will trickle back into the market and new warehouse activity, followed by CLO issuance, will likely pick up toward the end of 2009 and early 2010.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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