The structured finance CDO sector was caught once again in the turmoil of uncertain warehouse lines, liquidation and a challenging pricing environment last week, as subprime lenders and the mortgages they originated continued to show strain.
For much of last week, market participants seemed to be waiting on the sidelines for the smoke to clear - largely regarding the fate of Fremont Investment & Loan and New Century Financial Corp.
As the market waited, Moody's Investors Service provided some reading material and fodder for reflection on last year's relatively kind credit environment when it released its annual tally of CDO upgrades to downgrades on Thursday. The ratio of CDO upgrades to downgrades in 2006 improved to 1.35 to 1 from the 1.24 to 1 ratio in 2005, the rating agency reported. Moody's also said that downgrades increased by 27% on the year, while upgrades increased by 39%.
An overall reduction in downgrades and a growing sample size contributed to a sizable reduction in downgrades targeted within the U.S. dollar-denominated structured finance CDO sector. Interestingly, even though it endured the most downgrades, the sector was the only one that actually experienced a year-over-year reduction in downgrade activity. Downgrade volume fell by 36% to only 45 tranches, from the 70 tranches Moody's downgraded in 2005.
The reduction in the number of tranches downgraded, not to mention a 58% increase in the number of structured finance CDOs in the market, led to a reduced downgrade rate of 2.8% for the sector, from 6.9% in 2005. Not surprisingly, deals issued in 2000, 2001 and 2002 experienced the most stress because of exposure to manufactured housing, aircraft leasing and franchise loans.
While the arbitrage cash flow CBO sector saw an uptick in downgrade activity - even though all but six of the transactions had been previously downgraded - its overall downgrade rate remained at a low 7% at year end. Moody's downgraded 37 tranches in 29 transactions within the sector last year, compared with only six downgrades in 2005. Meanwhile, the arbitrage cash-flow CLO sector, buoyed by a benign corporate credit environment, remained strong with only eight tranches from seven transactions downgraded and an overall downgrade rate of 0.6%.
Moving on to the upgrades, some 61% were due to an improvement relative to closing-date ratings, while 14% of the upgrades were due to ratings that were restored to closing-date levels. The CDO types that were the most active in terms of downgrades were also the most active in terms of upgrades, with arbitrage cash-flow CBOs, structured finance CDOs and synthetic arbitrage CDOs leading the pack. Arbitrage cash-flow CLOs were also well accounted for, despite little downgrade activity.
As far as this year's CDO performance expectations, Moody's noted that the "favorable conditions" for CDOs appear to still be in place this year. In fact, year-to-date, the upgrade to downgrade ratio is 1.7 to 1 -and 1.8 to 1 when Moody's watchl isted transactions are added. Of course credit performance will largely depend on corporate credit trends this year, and structured finance CDOs - at least those issued after 2002 - will alsso depemd on the residential real estate market.
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