This is the second of two parts of an article examining the dilemma confronting CLO mangers who wish to improve their portfolios by trading rapidly deteriorating loans for better-performing so-called "deep discount" loans. This portion focuses on the industry's call for reform and suggests solutions to this problem.
Calls for Reform
In the current market environment, it should come as little surprise that deep discount provisions have emerged as an important topic in the CLO industry. In January 2009, the Loan Syndications and Trading Association (LSTA) formed a CLO committee comprised of portfolio managers, attorneys and other industry professionals to, among other things, encourage managers, investors, rating agencies, regulators and other industry participants to cooperate in an effort to ease the negative impact of distressed loan trading on CLO OC tests. On March 6, in response to the groundswell of inquiries from the LSTA and others, Moody's Investors Service issued a release entitled Moody's Comments on Deep Discount Substitution Amendments. In its release, Moody's directly addressed a potential mitigant to the deeply discounted loan valuation problem - deep discount substitutions.
Deep discount substitutions permit CLO managers to use the proceeds of the disposition of a CLO loan that itself does not constitute a deep discount loan to purchase a substitute loan that is not required to be characterized as a deep discount loan, even though such substitute loan would, under normal circumstances, meet the criteria of a deep discount loan. Subject to certain conditions, a number of which are described below, the par value rather than the purchase price of any such substitute loan is used to compute the numerator of the OC test ratio. Substitutions of this nature enable managers to avoid the dilemma described above, since such substitutions do not require managers to choose between improving the quality of the CLO portfolio and negatively impacting the OC tests. While a limited number of cash flow CLOs in the market already include a feature permitting loan substitutions of this nature, the majority do not.
The benefit of such deep discount substitutions can only be recognized if the substitute loan meets certain enumerated criteria, which relate primarily to the improved credit quality of the substitute asset when compared to the disposed of asset. Moody's set forth a number of recommended criteria in its June 24, 2004 publication. These criteria essentially (i) provide safeguards to ensure that the credit quality of the portfolio following such substitutions is maintained or improved, (ii) establish a floor value as a percent of par for substitute assets, and (iii) provide certain limits on the aggregate principal amount of such substitutions. The purpose of these criteria is to effectively mitigate the risk that managers will manipulate the par value of the CLO portfolio in order to improve the OC tests ratios at the expense of credit quality.
In its March 6 release, Moody's confirmed that it would be amenable to amendment proposals that were "in line with" the deep discount substitution provisions set forth in Moody's June 24, 2004 publication. The release further indicated that Moody's will also consider deep discount substitution provisions that "do not conform to some or all of the conditions" set forth above on a "case-by-case basis."
Searching for Solutions
To date, a number of cash flow CLO managers have pursued amendments to their CLO indentures in order to allow for deep discount asset substitutions. Such amendments generally require confirmation from the rating agencies rating the transaction that the amendment will not result in a downgrade or withdrawal of the existing ratings on the CLO notes. Many indentures also expressly require that a majority of the holders of the controlling class, together with a majority of any other class of noteholders materially adversely affected thereby, consent to such amendment in writing.
To date, proposed amendments to CLO indentures to allow for deep discount substitutions have been confronted with substantial resistance. For the most part, this resistance has not been driven by the rating agencies. To their credit, rating agencies have generally indicated a willingness to provide "no-downgrade" confirmations for deep discount substitution amendments, even in cases where the proposed criteria for such substitutions provides managers with more flexibility than the requirements set forth in the June 24, 2004 Moody's publication.
Resistance to deep discount substitution amendments has come in large part from the senior-most class of noteholders in the CLO capital structure. In many ways, this opposition is surprising since such amendments represent a measured and reasonable response by CLO managers to provisions in CLO indentures that have ceased to operate as originally intended. Moreover, by permitting the substitution of deteriorating loan assets for loan assets of better credit quality without being penalized for purposes of the OC test, these proposed amendments properly incentivize CLO managers to make trades that will improve the overall credit quality of the CLO portfolio. This improvement in credit quality accrues to the collective benefit of noteholders on every rung of the CLO capital structure. Resistance may, in many cases, be due to the complexity of the deep discount mechanics and a lack of information regarding the implications of the proposed amendments.
Conclusion
As loan prices linger at historically low levels, a number of cash flow CLOs are struggling to comply with their OC tests, due in large part to deep discount provisions in the underlying CLO documentation that do not reflect current market realities. These provisions, initially imposed to protect the credit quality of the CLO portfolios, no longer serve their intended purpose. Instead, they operate to effectively disincentivize managers from making portfolio-improving loan substitutions. Under these circumstances, it is imperative that managers, rating agencies and investors engage in open dialogue in a collective effort to solve the CLO deep discount dilemma.
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