As the first European CDO with a 100% European asset pool was downgraded last week due to faltering credit quality, the outlook for more downgrades might be graver than originally expected.

Sirius Finance 2000 Plc was downgraded last week, and all tranches of notes were affected: a 52.6 million Class A tranche was downgraded to double-A-plus from triple-A; a 67.9 million Class B tranche was downgraded to triple-B from single-A-minus; and the Class C notes suffered a downgrade to single-B-plus from triple-B.

With layoffs continuing to increase, recessionary woes in Europe might be worse than originally expected. Furthermore, corporate earning levels are below expectations and the debacle of the railtrack has not helped either, analysts say.

Up until now, CDO downgrades were chiefly expected to touch only European CDOs with significant exposure to U.S. assets (see ASR 10/15), but that is likely to change.

Assessing the damage

According to Dresdner Kleinwort Wasserstein: "In the wake of 11 September and with the prospect of a recession in the U.S. and a sharp economic slowdown in Europe, the status quo [of CDOs] may begin to be challenged." With the credit quality of structures that are exposed to the airline, hotel, insurance and tourism under threat, as new issues begin to mount onto the pipeline, investigating the potential for further downgrades is a necessary route to take.

In a report issued on European CDOs, Dresdner investigates whether rating agencies have adequately accounted for the frequency and size of rating actions that may affect some underlying pools after Sept. 11.

If the figure is greater than what the agencies previously assessed in default models or if the timing of these actions is earlier than they had anticipated, then the initial levels of credit enhancement may no longer be valid to support the current ratings, prompting tranches to be downgraded.


Leonardo Synthetic PLC skimmed by mostly unscathed when compared to the magnitude of downgrades within the airline sector.

The transaction involves the transfer of credit risk on a revolving pool of aircraft-related loans and letter of credits. Moody's Investors Service downgraded only the 30.4 million Class C notes of the transactions last week to A3 from Aa2 and simultaneously confirmed the ratings on both the 56 million Class A notes at Aaa and the 84 million Class B notes at Aa2.

According to Moody's the risk transferred to the credit-linked notes in the transaction is affected by whether the airline which owns the aircraft has gone bankrupt or refused to pay amounts due to the credit default swap servicer, Banca Intesa Banca Commerciale Italiana S.p.A; and the value of the aircraft has decreased, so that it is insufficient to repay the outstanding financing on the aircraft. Only if both situations occur at once is there a loss determined that must be "covered by the available credit enhancement, commencing with the 6.5% first-loss piece."

However, if the airline were in default the servicer would react by putting the aircraft for sale. After one year, if the sale has not been completed the collateral value will be the aircraft's base value, which Moody's defines as "the price the aircraft gets in a liquid market between a willing buyer and seller and not the fire-sale' price which might be obtainable in the current market." Three independent appraisers determine this base value.

While the ratings action is attributed to both the negative evolution in the operating earnings and cash flows in the airline industry and the softening of the base values of secondhand aircraft since Sept. 11, the underlying base values of the Leonardo transaction are regarded as more stable than current market values, hence prompting only a one-notch downgrade. Under present market conditions for airline industry transactions, a base value figure would be considerably better than current aircraft valuations.

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