Market value ABS CDOs have taken a beating from declines in the value of their underlying collateral. And now, the recent downgrades on synthetic CLOs backed by total return swaps have demonstrated that falling prices in the loan market have put CLO structures at risk too.
From the end of June 2007 through Jan. 16, the average bid on the leverage loan market fell from $98.74 to $92.49 (a 6.4% drop) while the average bid on the most liquid leveraged loans, the SMi U.S. 100, fell from $100.02 to $94.36 (a 5.7% drop), according to the Loan Syndications and Trading Association/ Loan Pricing Corp., whose mark-to-market pricing data was cited in a Fitch Ratings report.
"Back in the summer of 2007, we saw loan prices take a four-point decline within a week span, which is pretty large in such a short period," said Richard Hrvatin, managing director at Fitch Ratings. He noted that since November the decline has been slow and steady.
As a result of the drop in value, Fitch downgraded and placed on Rating Watch Negative 28 tranches of total rate of return (TRR) CLOs. The rating agency also placed another 37 tranches on Rating Watch Negative.
The deals were put on watch so that the ratings agency could monitor where the credit cycle is heading and how market prices are holding, Hrvatin said. "We thought it was justified to look at the market as a whole as opposed to just a few specific transactions."
The rating actions affect 24 out of the 27 transactions in the Fitch-rated TRR CLO market, Hrvatin said, noting that while these deals have performed well from a credit perspective, because of price declines they have a decreased ability to withstand additional market value or credit losses. The three transactions that were not affected by the rating actions were from a much earlier vintage and, as a result, were very seasoned and had a lot of retained cushion.
Among the downgraded transactions were the Aladdin Managed LETTRS Fund managed by Aladdin Capital Management; the Hartford Leveraged Loan Fund, the Stedman Loan Fund, the Beecher Loan Fund and the Bushnell Loan Fund managed by Hartford Investment Management; the Canal Point I and Canal Point II fund managed by Princeton Advisory Group; the Fall Creek CLO managed by 40/86 Advisors; the Malibu Loan Fund managed by Aegon USA Investment Management; Structured Enhanced Return Vehicle Trust (SERVES) 2006-1 managed by PPM America; the Rivendell Loan Fund managed by Nationwide Mutual Insurance Co. and the Silver Crest Loan Fund.
Structure of Impact
TRR CLOs are a hybrid of cash CDOs, market value and synthetic transactions, according to Hrvatin. The market value component has a trigger that can cause the deal to unwind if there are losses up to a given point. Instead of owning a security with an interest in a cash portfolio, a TRR CLO investor owns a credit-linked note that references a loan portfolio through a total return swap or a credit default swap.
Typically, the lowest rated notes in the liability structure, which make up the triple-B category, are in the first loss position. While there might be a nominal equity portion, the BBB' rating is highly reliant on excess spread over the years to either reimburse for defaults or for market value losses. These deals are actively managed by a third party and commonly have a seven-to-10-year revolving period and a short amortization period of three years or less.
A Bright Spot
Unlike a lot of other structured finance transactions, synthetic CLOs linked to TRS do not always share the same structure, which makes it hard to determine where these deals derive their credit ratings from and where the losses are.
"You have a lot more variation in these structures. And that is the part that makes it hard to analyze because it is much less of a one size fits all," said Joel Telpner, partner at Mayer Brown. The rating of the deal, depending on the structure, can be a function of what is happening to the collateral and/or on the synthetic side, Telpner said. "Even if the loan portfolios aren't going into default, these deals are being affected by the fact that valuations of these loans have gone down."
However, falling prices appear to have bottomed out recently, market participants said, which offers good buying opportunities in the sector.
Furthermore, given the transparency in the synthetic CLO market, which allows for appropriate credit analysis of the assets going into the portfolio, the synthetic CLO market can be an attractive buying opportunity right now, according to Telpner. The market is also attractive in terms of the smaller sized deals that can be done, which enables originators to tailor the amount and structure for a specific single investor as opposed to doing only large transactions.
A synthetic CLO also reduces the warehouse risk, which has stunted issuance on the cash side. In a typical cash or hybrid CLO, managers start accumulating assets three to six months before closing a deal, during which time the value of the assets can start to decline. But in the case of a synthetic CLO deal, managers are able to identify what they are going to invest in and what their portfolio will look like and can have the deal rated on that basis.
"You do not really have to acquire assets prior to closing; you can in effect do it simultaneously with closing, eliminating the warehouse risk," Telpner said.
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