By Natasha Chen, vice president/senior analyst, Moody's Investors Service
Increasingly, CDO managers seek the flexibility to continue reinvesting after the reinvestment period has ended. Reinvestment is generally limited to unscheduled principal proceeds, as well as proceeds from the sale of credit-improved and credit-risk securities. Moody's is concerned that credit risk posed to the rated noteholders that was not contemplated in the original modeling of expected losses may be introduced to the transaction as a result of this practice.
In Moody's opinion, a collateral manager's ability to reinvest unscheduled principal proceeds and proceeds from credit-improved and credit-risk sales in actively managed collateralized debt obligations after the end of the reinvestment period should be subject to specific criteria intended to lessen the likelihood that the collateral manager's reinvestment decisions will have an adverse effect on the rated noteholders' credit risk exposure.
CDOs generally have fixed reinvestment periods during which time certain proceeds may be reinvested in additional collateral subject to specified reinvestment criteria. Following the end of the reinvestment period, these funds would normally be used to amortize the principal of the CDO's notes in accordance with the principal proceeds waterfall set forth in the transaction documents.
In Moody's opinion, this additional risk is mitigated when all of the following criteria are satisfied after giving effect to the proposed reinvestment:
* The weighted average rating factor (WARF) of the portfolio is in compliance.
* The Caa'/below-investment grade concentration limitation is in compliance. If there is no defined Caa' concentration limitation in a high yield deal, the Caa' exposure should generally be no more than 5% (7.5% if the transaction is a CLO where the senior implied rating is being used to compute the size of the basket). However, Moody's will consider different percentage limitations depending on deal structure and modeling assumptions. For investment-grade deals without a below-investment grade basket, the limits may vary according to transaction structure.
* The junior-most amortizing overcollateralization (O/C) ratio is passing at a level that is sufficient to support the initial ratings. This level, which is fixed at the inception of the deal, is typically set several percentage points above the trigger level.
* The then-current ratings of the senior notes are no lower than their initial ratings, and the then-current ratings of the mezzanine notes are no lower than one subcategory below their initial ratings.
* The weighted average life test or maximum maturity profile test is in compliance. If there is no such test after the reinvestment period, the scheduled maturity of the purchased asset should be no later than the scheduled maturity of the asset that generated the reinvested proceeds.
* Such other tests that are deemed relevant to the maintenance of credit quality for the rated notes are satisfied.
Comparable variations on the above criteria would be reviewed on a case-by-case basis.
Using modeling as an alternative
As an alternative to including in the governing documents structural provisions that mitigate reinvestment risk, Moody's will also consider modeling the level of increased credit risk that is introduced when managers have the option of post-reinvestment period reinvesting. This analysis will look at the potential impact on expected losses to the holders of rated notes.
Moody's models for corporate cash flow CDOs typically assume a probability of default based on the covenanted maximum weighted average life of the collateral pool at inception. During the reinvestment period, the maximum weighted average life of the pool is generally equal to the maximum weighted average life at inception less the number of years of the reinvestment period that have passed.
Thereafter, without relevant limitations on reinvesting, any maximum weighted average life constraint at the end of the reinvestment period would become ineffective. Portfolio turnover could lead to an increase in the weighted average life to as high as the number of years remaining in the deal. This could add as much as four additional years of credit risk in a typical corporate cash-flow CDO. To the extent that structural provisions are not implemented as mitigating factors to this risk, Moody's would assume a probability of default based on the full length of the transaction.