Moody’s Investors Service may upgrade some $237 billion of CLOs as a result of a change in its ratings methodology.
The rating agency said today it has placed 4220 tranches from 782 CLOs that are currently rated 'Aa1' and below on review for a possible upgrade. The total current outstanding balance of the tranches is $237 billion, or approximately 80% of all outstanding cash flow CLO tranches.
The magnitude of the potential upgrades ranges from one to three notches for the most senior tranches and from one to five notches for mezzanine and junior tranches.
The review is a result of changes in Moody's methodology for rating CLOs. Most notably, it has removed a 30% default probability stress that it put in place in February 2009 in response to the extraordinary disruption in the capital markets following the collapse of Lehman Brothers.
“With credit conditions relatively more stable now and default rates low for corporate credits, Moody's will both remove the temporary stress and institute methodology adjustments, reflecting a review of historical default rates that includes the experience from the recent credit crisis," the rating agency said in a statement.
Other changes to the ratings model include a recalibration of the default probability and recovery rate assumptions in order to reduce the likelihood of future rating volatility resulting from assumption changes.
Moody’s new methodology lowers the level of credit enhancement that it deems necessary for a CLO tranche to achieve a specific rating. However, these levels will generally still be above those in effect prior to the financial crisis.
The rating agency expects to complete its review within six months.
It said the potential upgrades will be in addition to any rating actions taken recently as a result of improvement in the performance of the pools of loans backing the CLOs.
Because CLOs managers generally buy and sell assets used as collateral, rather than originate loans. The kinds of loans they can buy, and the covenants that these loans must be subject to, are spelled out in the CLO indenture. For this reason, Moody’s modeling of CLOs is generally based on assumptions derived from the transaction covenants, rather than the CLO’s current portfolio. However, if a CLO is structured to have a static pool of collateral, or it no longer permits reinvestment, Moody’s modeling will instead reflect the characteristics of the actual collateral pool.
An earlier version of this story incorrectly stated that the review affected tranches from 611 deals; the correct figure is 782 deals — 611 of which are U.S. deals.