If one debt instrument could be designated a long shot in this environment, distressed debt CLOs might be the frontrunner. So what's the story with the two deals on watch for upgrade - a great rarity for any CDO - that are backed by, primarily, distressed loans?

After 12 months of record-making downgrades, more than one investor probably flinched when Moody's Investors Service issued an upgrade watch last week for a few classes in both ARK II CLO 2001-1 and Endeavour LLC CDOs. While a watch doesn't translate into an upgrade per se, insiders believe its quite likely. Recoveries for both vehicles have been much more quick to actualize than even the ratings agencies predicted.

ARK II, a static pool of distressed loans, closed in October 2001 and is managed by Patriarch Partners. CIBC World Markets is the underwriter. Endeavor, brought to the market in December 2001 by Banc of America Securities, contains a static pool of distressed loans and investment grade (IG) asset backed securities. It is managed by PPM America.

According to Moody's, the $88.97 million in Class B Floating Rate Notes in ARK II are on watch for upgrade, while a total of $55 million in Class B-1 and Class B-2 Fixed Rated Term Notes are on watch for Endeavour.

While the CDO market is known for its innovations in risk dispersion, distressed debt renditions garnered skepticism when they were introduced. The first such vehicle, ARK I, another CIBC-managed CDO, priced in December 2000. Before the deal priced, new approaches and methodologies were created.

As for ARK II and Endeavour, both CDOs priced shortly after the Sept. 11 terrorist attacks when investor confidence plunged. And both contain troublesome bank loans in a tough corporate credit environment. At the time, some players doubted the deals could get done.

"Irrespective of the Sept. 11 attacks, I think investors, at that time, felt that the managers specifically had demonstrated their ability to manage - 2001 had been a very difficult environment even pre-Sept. 11," said Rob Inglese, managing director for CDO origination and structuring at CIBC. "And that was really the key, the manager felt that the long-term prospects for the portfolio really hadn't been changed by Sept. 11."

Even those who created the specialized ratings tests, including Moody's Senior Analyst Phillip Mack and Jim Leahy, senior credit officer, have been titillated.

"I was a little surprised at how quickly they realized their recoveries," said Mack.

"Right off the bat, within six months to a year of closing, they starting paying off massive amounts of debt," said Leahy, explaining that the weighted average life for Class A notes in both vehicles was initially targeted at three to three-and-a-half years. With Endeavour, for example, the Class-A notes have already been paid off, two years ahead of schedule, as is the case for ARK II. That CDO paid off its Class-A notes in December 2002.

While seniornote holders probably weren't thrilled to lose two years of good interest, the subordinate debt holders, arguably the true heart of a CDO, are certainly poised to party. And such performance levels beg the question: Have any similar vehicles achieved such a quick time frame for payoff?

"I don't think so, and we've only done three of these," said Mack.


Information regarding the performance of ARK I is expected to hit the market shortly, sources said. According to CIBC's Inglese, after a review, analysts will probably find the first ARK's performance quite similar to ARK II.

"CDOs, being an efficient funding mechanism, proved very valuable for the manager to efficiently price the loans and do a bulk purchase, which is something that was very beneficial," Inglese said. "ARK I was really the first time that we're aware of that we were able to marry CDO technology with the asset class of distressed debt bank loans."

While the only significant difference between both CIBC-backed CDOs was the loans in the portfolio, ARK II did had the benefit of time. Some minor structural improvements were made with ARK II, a key one being the ability of the collateral manager to advance new funds into some of the troubled companies was made easier. "And that proved to be critical in some cases to the manager being able to turn around some companies," noted Inglese.

"I would agree that these were good transactions," said Leahy. "The reason is that distressed loans are tying up capital at the banks and they're very labor-intensive to work out. From the bank's point of view, they've sold the loan at a fair price, they no longer have to keep loan loss reserves against the loan, and it's been sold to an expert who's purchased it at the fair price and who's adept at receiving full value."

But while the banks get to off-load underperforming assets from their sheets, don't CDO investors simply inherit the ulcers of distressed debt?

Since the assets were purchased at a significant discount, Mack explained, a large level of "par" is built into both CDOs. "So if you realize recoveries even just somewhat above what you bought them for, the deal will perform quite well," he said.

As for the future marriages of distressed CLOs and CDOs, neither banks nor rating agencies would gander a guess. One source noted that, in the near future at least, "banks are not aggressive sellers of these types of assets right now."

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