Analysts have adopted a bearish stance on German cash mezzanine CLOs, saying they expect the deteriorating German economic landscape and shifting rating methodology to further pressure performance in this asset class.
"Besides pool-specific weakening, the Damocles sword of a mix of weakening economic SME prospects, negative rating migration expectations partially accelerated by stricter rating assessments and uncertainty related to the refinancing of such transactions is hovering over German cash SME CLOs," Unicredit analysts said, adding that the secondary market for German cash mezzanine CLOs has consequently dried up in the current environment.
Last week, a new default occurred in PREPS 2006-1. In total, there have so far been four defaults in PREPS 2006-1 that have accumulated to an amount of Ã27 million ($40 million). The latest default follows problems within the H.E.A.T SME program as well as the Pulse program, both of which experienced defaults in recent months.
The credit quality of most of the SME securitized portfolios has weakened, with some pools performing worse than others, as in the case of Force 2005-1, PREPS 2004-2, PREPS 2005-2, CB Mezzcap 2006-1 and PREPS 2006-1. As the economic landscape in Germany becomes more challenging, it's likely to add further performance pressures on these deals.
"We expect the German economy to not be fully resilient to the current global economic turmoil, hence also the SME sector is not immune as SMEs account for at least 95% of German companies," analysts said. "In an economic moderation scenario, the number of SME defaults is likely to increase, thus this will further influence the future performance of particularly subordinated debt backing German SME mezzanine cash CLOs."
However, poor pool performance hasn't been the only culprit behind the defaults of late. In the current credit crisis, the rating agencies have responded with stricter rating proceedings that now require an increase in credit enhancement levels and have as a result driven the negative rating decisions for existing mezzanine SME CLOs.
Specifically, Fitch Ratings' new CDO rating methodology has tightened considerably. Fitch's new CDO rating framework takes into account much more conservative inputs, particularly in the case of pool concentrations -- obligor, regional, industry. In the last month, Fitch placed H.E.A.T Mezzanine S.A. Compartment 2 Class A and B notes, StaGe Mezzanine Societe en Commandite Simple's Class A and B notes and the Class A and B notes in the PREPS 2004-2 deal on ratings watch negative.
Although these transactions benefit from excess spread and a principal deficiency mechanism for excess spread trapping, the securitized debt instruments comprising the portfolio are deeply subordinated, the rating agency noted.
The agency said that, while no significant portfolio deterioration has been observed, the negative watch status has, to a large extent, been directly driven by CDO methodology change. Fitch also announced that it is currently revising its default assumptions for European SME CLOs.
As a result, these transactions rated by Fitch, which include PREPS, Force, SMEZZ, H.E.A.T and Prime Funding, are likely to face more pressure in terms of negative rating migration. "Given such potential downgrade expectations on German SME mezzanine CLOs, stakeholders are already proposing to withdraw Fitch's ratings on the respective transactions," Unicredit analysts said.
However, not all transactions bear similar downside risk, as there are material quality differences among the programs issued. The Preps 2004 -1 and the Pulse 2006-1 series are better quality and are thus performing well even under the stricter methodology.
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