In one fell swoop, Moodys Investors Service today put nearly all rated tranches of U.S., European, Middle Eastern and African cash-flow CLOs on review for a possible downgrade, excluding the most senior triple-A tranches.
This action applies to approximately 3,600 tranches totaling $100 billion from 760 deals.
On Feb. 4, Moodys revised its ratings methodology for CLOs, increasing its default probability assumptions for underlying credits in CLOs by 30% across all rating categories (For more on Moodys review see the excerpt from a Moodys statement below).
Moody's model for forecasting the default rate for speculative-grade companies projects the five-year cumulative rate will reach 30%.
Moodys will treat assets with negative outlooks, or those that are on review for a possible downgrade, the same way it would if the CLO had already been downgraded by one or two notches, the rating agency said in the statement.
Moodys did not place any triple-A-rated tranches on review because those tranches have underlying credit support, cash flow diversity, deleveraging mechanisms and diminished reinvestment opportunities. Moodys default analysis indicates that triple-A-rated tranches have enough protection to survive a 50% collateral default rate over the life of a transaction. However this could change and downgrades could occur, Moodys said.
Two Stages of CLO Rating Review (from a Moody's statement)
Moody's will conduct its CLO ratings review in two stages. In Stage I, which will begin immediately, Moody's will use a parameter-based approach to calibrate the extent of downgrades to tranches currently rated single-A and below in the vast majority of cash flow CLOs.
Any senior-most CLO tranches that appear to have significantly weaker than average structures and portfolios may be placed on watch for possible downgrade at that time as well. In Stage II, which is expected to begin at the end of March, Moody's will perform a more comprehensive analysis by modeling each CLO individually. At that time, additional rating actions will be taken as necessary for all rated liabilities, including tranches currently rated 'Aa' and 'Aaa'. Moody's expects to complete Stage II by the end of the second quarter of 2009.
The collateral portfolio characteristics that will be examined as part of Stage I include (1) the current rating, (2) the level of over-collateralization (O/C), (3) the Weighted Average Rating Factor (WARF) transition since mid-2008, (4) the absolute increase in percentage of 'Caa'-rated assets since mid-2008, (5) whether a tranche is currently, or is expected on an upcoming payment date, to pay-in-kind (PIK), and (6) the concentration of structured finance securities, such as other CLOs, in the collateral pool.
Moody's adopted a parameter-based approach for Stage I for two main reasons.
First, our sample testing shows that an overwhelming majority of tranches rated single-A or below are expected to experience at least a four-notch downgrade on average which, in the case of the single-A's, would put them on the boundary between investment grade and speculative grade. In particular, single-A's will be considered for downgrade by five to eight notches if a deal's single-A O/C is less than 110%, its WARF has increased by more than 10%, its 'Caa' bucket has increased by more than 5%, the tranche is PIKing, or it has more than 5% structured finance assets.
Second, certain parameters, as described above, could be used to identify potential performance differentiations across most CLO transactions, enabling us to make that distinction in advance of a more time-consuming credit analysis involving cash modeling.
Moody's emphasized that the parameters serve as guidelines for rating committees, which will individually assess each transaction by taking into account the CLO's own performance data, deal-specific document features, structural protections, and the collateral manager's track record.
The tranches rated 'Aa' and 'Aaa' in CLO transactions do not lend themselves to aparameterization approach, even as a first step in the credit process, as the unique portfolio characteristics and structural features of the CLOs tend to differentiate performance more at the top end of the capital structure. Most of these senior tranches currently rated 'Aa' and 'Aaa' will be reviewed during Stage II.
During this Stage II review, it is expected that a number of junior Aaa-rated tranches and Aa-rated tranches will be downgraded by two to four notches on average, with a wide range of outcomes that depend on the specific transaction, and a small number of senior-most Aaa-rated tranches may also be downgraded.Because Stage II will involve modeling the entire capital structure of the CLO, it may also lead to further ratings actions on tranches currently rated below 'Aa'.