Ongoing pressure on the credit ratings of some of the largest financial institutions could result in a minor shakeup in the ranks of CLO trustees.
Nearly all CLOs designate a single bank at closing to serve as the trustee, collateral administrator, and paying agent. This bank’s responsibilities include maintaining a collateral database, reconciling the portfolio with the manager, producing compliance and note valuation reports, and distributing the proceeds on the payment dates to the appropriate parties, in accordance with the waterfall.
CLO deal documents also outline ratings eligibility requirements and resignation guidelines for banks performing these roles, typically the equivalent of Baa1 or better.
On Feb. 15, Moody’s Investors Service placed its ratings on a number of banks and securities firms on review for downgrade. Citibank, which currently has long-term rating of 'A1', just three notches below Baa1, is the closest to the wire, followed by Deutsche Bank Trust Co.at 'Aa3', or four notches from the threshold. Deutsche and Citi are among the smaller players in this market, however.
Wells Fargo Bank is also rated 'Aa3' with a negative outlook, although it is not under review for a possible downgrade.
U.S. Bank and State Street Bank and Trust both have an 'Aa2' long-term rating, putting them five notches away; both have negative outlooks, though neither is under review.
Bank of New York Mellon, another big player in this market niche, is under review for a possible downgrade but is currently rated Aaa, giving it a much wider margin than some of its competitors.
Moody’s isn’t the only ratings agency that has downgraded the credit ratings of a number of major financial institutions while maintaining their negative outlooks. Standard & Poor’s currently has a long-term rating on Citi of 'A-', with a negative outlook.
The rating agency has Deutsche, Wells and Bank of New York Mellon’s long-term rating at 'A+' and State Street’s at 'AA-'; all of these banks have negative outlooks as well.
In the March 5 issue of its CLO Interest, Moody’s warned that this ratings pressure could eventually result in some banks becoming ineligible to serve as a trustee, making it necessary for them to be replaced by the deals’ issuers.
Moody’s analyst Andrew Worthington said in the report that, the documents of U.S. CLOs sometimes specify that a trustee resign immediately in the event it is downgrade below a stated threshold. However, the trustee must provide written notice of its resignation to the co-issuer, the noteholders, and rating agencies at least 60 days before the effective date. If the trustee does not resign, a vote by the majority of the noteholders can remove the trustee at any time. The issuer can also remove a trustee.
Likewise, Worthington wrote, European CLOs generally stipulate that deal parties such as the account or custodian bank maintain certain eligibility criteria, such as a Moody’s short-term rating of P-1 and a long-term senior unsecured debt rating of 'A2'. However, unlike U.S. CLOs, when this requirement is breached some documents recommend that the deal use “reasonable endeavors” to replace the affected party while others suggest that this can be remedied, rather than requiring an immediate resignation.
Moody’s said the myriad actions necessary to replace an institution that plays so many roles may overwhelm the deal parties, particularly the trustee, and lead to servicing delays and operational mistakes. “Although replacement would be an operational challenge, and even disruptive, we believe the credit impact would be limited to operational mistakes, which would ultimately be correctible,” Worthington said in the report.
“There are a lot of behind-the-scenes tasks, such as the tie out [reconciliation] of the portfolio between the trustee taking over and the one resigning,” the analyst elaborated in a telephone conversation. Also, “all of the collateral has to be re-register with new bank, all bank agents notified of new wiring instructions for collateral. In my mind those are the two biggest challenges. Re-registering is not something a trustee can do overnight, it usually take several weeks to accomplish… sometimes agent banks are not responsive. A tie out can be quick or painful, depending on how relations are between the two trustees.”
The ratings agency warned that future downgrades may trigger breaches in the ratings eligibility of one or more banks at the same time, forcing an issuer to seek a successor trustee from what could be a shrinking pool of eligible candidates. “Although this situation may be a serious problem for some, the effective date of the transfer of responsibilities to the successor trustee may well be manageable for all related parties,” it said in its CLO Interest.
The report said cited U.S. Bank’s acquisition of the securitization trust business of Bank of America Merrill Lynch in 2011 as a recent example of successful transfer. The deal involved approximately 2,153 active securitizations, including a number of collateralized debt obligations, according to a statement issued by U.S. Bank at the time.
In this case, Moody’s said, the risk of a trustee downgrade presented more of an operational challenge than any credit risk to the deal.
Ratings downgrades aren’t the only reasons the trustee in a CLO may be changed. “Most CLO documents provision for a resignation or removal of the trustee, but the issuer will have to appoint a successor trustee, and typically the resignation or removal does not become effective until the successor trustee accepts the appointment,” Moody’s senior analyst Per Min Xu said.