Two loans have defaulted from Sanwa Bank's $2 billion Excelsior collateralized loan obligation, triggering an early amortization event that will result in the deal repaying in less than a year - a first-time occurrence for the CLO market.
According to people familiar with the deal, the early amortization event happened because the amortization triggers on the deal were set too tightly. As such, when the two defaulted loans - totaling just $8.5 million - wiped out the cash collateral account, the busted loans reduced the account to below 50% of its original level, which triggered the deal to repay.
"Setting such tight triggers will force you into potentially having an early am event, which is exactly what happened," said one source, an expert in this sector.
What happens in an early amortization event, the source said, is a deal's principal is paid back to the investors prematurely, and an issuer must reflect the payouts on the balance sheet much sooner than expected.
"That means their capital relief disappears," the source said. "They wind up having to amortize their up-front expense over a much shorter period of time."
In this case, the source said, the bank will have to write off the remainder of the amortization schedule over the remaining nine months of the deal. The class A portion of the deal should now be redeemed in full by April 2000, and the subordinate tranches should be redeemed by May 2000, said the source.
Observers differ on the reasons why the triggers, set to fire after a loss of $8.5 million, were set so tightly.
One line of thinking blames Sanwa for its strict loan-loss requirements. "They wanted a low credit enhancement," said one source. "They wanted capital relief at a low cost, so they had to set a tight trigger."
Yet others place the blame with the rating agencies, saying they believed that the triggers were required to get favorable ratings from Moody's Investors Service and Standard & Poor's Ratings Group, which rated the deal Aaa and AAA, respectively.
Neither rating agency could be reached for comment on any actions taken on the Excelsior deal, nor would they say whether they had placed the deal on their watch lists for possible downgrades.
The defaulted loans were not believed to have exposure to the emerging markets sector, a market that had experienced considerable liquidity troubles late last year, and had caused spreads on some of these deals to widen.
A source close to the bank felt that the higher-than-expected expenses caused from the early am would not bite into the bank's net income statement for year end, because the large amount of assets backing the bank would cushion the loss.
Though the source was not certain. "The bank has $30 billion in assets alone in this branch," the source said. "But I don't know. It's a $2 billion portfolio."