CIBC World Markets last week began marketing Ark II, the sequel to the first visible distressed debt CDO, which, back in January, set precedent for the much talked-about and widely anticipated sector - although deal flow has yet to match market interest.

Like Ark I, this new deal is in the spotlight because it's groundbreaking, being the first such CDO to test the waters of this revised, post-Sept. 11 economic landscape.

One perspective on the sector is that, if distressed debt CDOs were drawing interest before Sept. 11, players would be seriously considering it now, with worsening corporate credit and industry downturns inspiring banks with large portfolios to creatively manage their risk exposures. But market players are waiting to see if these deals can really get done in today's conditions.

"There's going to be a need and an interest in this structure," said one bank CDO analyst. "But the question is, will there be a market for it? It's hard enough to predict the future of any part of the CDO market right now. Distressed debt is probably the least certain of all the CDO sectors, particularly because there's been the least precedence."

Bank of America, for example, postponed its $500 million Endeavor CDO after the terrorist attacks, which would have been the second CDO with a significant portion of distressed debt since Ark I.

CIBC supplying collateral

In the premarketing stage, Ark II is structured as a $700 million two-part deal, backed by a combination of performing and distressed assets, mostly loans, investors said. The MBIA-wrapped triple-As have been hovering in the mid-40's to 50-basis points over Libor range. Reportedly, the A-class has a stand-alone rating of AA'/'Aa2' (Standard & Poor's/Moody's Investors Service). The deal is said to have a weighted average rating factor (WARF) of 5574.

Like Ark I, Patriarch Partners is collateral manager for the CDO, and CIBC is underwriter. Unlike Ark I though, CIBC is not only underwriter on the deal, but is also sourcing the collateral, where in the previous deal, Patriarch was collateral manager for BankBoston, which was reportedly aiming to shed some of its overlapping exposure to collateral created in the merger of Fleet Bank with Bank Boston and Sanwa Business Credit.

Essentially, the deals are structured such that the bank is outsourcing the workout function of a portion of its distressed portfolio to Patriarch, which then becomes servicer on the collateral.

Fleet's deal was approximately $1 billion in size. The triple-As, which were wrapped by Financial Security Assurance, priced in the low 50's over Libor.

Credit perspective

on distressed deals

Much of the complexity in these deals is related to uncertainty in asset recovery values, which play a large part of the cashflow analysis of distressed debt CDOs. Obviously, one of the concerns is that, as there are more and more distressed assets in the marketplace, the realization of values could decline.

For example, if several airlines were to go belly-up simultaneously, the liquidation value of the aircrafts themselves would likely suffer, because the market would be saturated with used planes. Also, with fewer airlines in operation, there would be fewer parties interested in buying aircraft.

"It's tough to tell at this instance what impact the events will have on the distressed market," said David Howard, of the CDO group at Fitch. The impact of a larger distressed debt market on the CDOs has always been part of Fitch's stress scenario, Howard said.

"It's certainly an issue now because that scenario has been accelerated a little bit," he added. "I certainly think that the pipeline of distressed assets hasn't gone anywhere but up."

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