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According to Moody’s June Monthly Default Report, the European 12-month Speculative-Grade default rate
increased to 5.6% in Q2 2009, up modestly from 4.5% in Q1, but more sharply from 0.7% in Q2 2008. Moody’s
expects the rate to climb further to a peak of around 15% in Q4 2009, before easing to about 12.5% around
the middle of next year. In the U.S., the Q2 2009 Speculative-Grade default rate reached 11.0%, up from 8.0%
in Q1 and 2.4% a year earlier. The peak is expected at 12.9% in Q4. Just as the increase in U.S. default
rates has led that in Europe, the subsequent decline is expected to occur earlier in the U.S.— Moody’s
forecasts a substantial drop in the U.S. Speculative-Grade rate to about 5% by mid-2010.
The forecast of higher default rates through the end of this year is consistent with Moody’s understanding of a
number of highly leveraged companies that are in restructuring discussions, or facing liquidity issues as a
consequence of the economic downturn. The relatively slow reduction in the default rate outside the U.S. is in
line with Moody’s current global economic scenario, which envisages a gradual and painful economic “hook-
shaped” recovery. 1
A recent notable feature of the capital markets has been an increase in the level of bond issuance and a
narrowing of spreads, particularly for investment-grade companies. New issue volume for 2009 has outpaced
2008 and for US and Canada has reached about $82B. Most likely because of the large number of single-B
companies that need to refinance, single-B issuance has accounted for the bulk of the activity. Spreads have
come in from their post-Lehman-bankruptcy peaks, but interest expense for firms seeking to refinance is
generally higher than their existing interest costs.
Although there has been some issuance by European high-yield companies, the volume — about $8 billion —
has lagged that in the US, and as yet the capital markets have not refinanced European leveraged loans. For
a number of highly leveraged European companies, there will be increasing pressure on cash flow due to
amortization of Term Loan A facilities. For the time being at least, it appears that most such companies will not
be able to use the capital markets for refinancing as an alternative to debt restructuring.
The implication for CLO performance is that the near-term outlook remains negative. The economic
environment remains very weak and refinancing opportunities are few for the companies that most need them.
However, Moody’s default forecasts suggest that by the middle of next year, the situation is more likely to
stabilize. ❖
1
See “On the Hook - Update on Moody's Global Macroeconomic Risk Scenarios 2009-2010,” May 2009.
In June according to “Moody’s SGL Monitor: Speculative-Grade Liquidity” (July 2009), Moody’s Liquidity-
Stress Index, which measures the number of SGL-4-rated companies as a percentage of all SGL-rated
companies, fell to 17.1%, down from a six-year peak of 20.9% in March. This marks the third consecutive
monthly decrease and the first quarterly decrease of the Liquidity-Stress Index in two years. It is a possible
sign that intrinsic liquidity constraints on corporate borrowers are beginning to ease.
If firm liquidity is in fact improving, fewer of the speculative-grade issuers whose obligations are underlying
CLOs may face refinancing risk. Thus, they may be less likely to default on their debt obligations. This is
worth noting because, while the one-year default rate for SGL-4-rated issuers has historically averaged 19.6%
over the period from October 2002 to present, it was 22% in December 2008 and 35% in June 2009. This
suggests that in the current economic environment, defaults by speculative-grade issuers are more likely to
occur because of lack of liquidity and an inability to refinance.
Despite the signs of improvements described above, however, liquidity concerns will likely persist for some
time. Consumer demand and corporate revenues show continuing weakness, leaving many companies
starved of retained earnings needed to finance their activities. Additionally, many underlying issuers will need
to refinance their debt in the 2012-2014 period. Any that rely on uncommitted external financing at that time
will face ongoing liquidity pressures. Hence, liquidity will remain a key credit consideration for speculative-
grade issuers and CLOs that invest in their obligations. ❖
Arnaud Lasseron
Vice President - Senior Analyst
+1 (212) 553-7742
OC % Cash %
136 9
134 8
132
7
130
6
128
5
126
4
124
3
122
2
120
118 1
116 0
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
OC Cash
2
Moody’s key indices are based on our global EMS data, using trustee reported figures for 840 Moody’s-rated CLOs. OC is a simple average over all CLO
senior over-collateralization levels for tranches initially rated typically Aaa or Aa. Cash is calculated as a simple average over all CLOs of cash holdings as a
percentage of notional outstanding. WARF is a simple average of weighted average rating factors over all CLO deals. Caa Bucket and Defaults are simple
averages of Caa buckets and defaults as a percentage of notional of collateral outstanding over all CLOs. Note that historical averages could change over
time as a result of corrections by deal trustees or Moody’s EMS or late reporting deals.
CLO Weighted Average Rating Factor and Caa and Defaulted Bucket Sizes
Monthly Levels Averaged Across All Moody's Rated CLOs
January 2007 - May 2009
WARF %
3000 12
2900
10
2800
8
2700
2600 6
2500
4
2400
2
2300
2200 0
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
A flattened WARF and downtrend in the Caa-Bucket indices were due in part to slowing downgrades on the
underlying pools, as well as to technical reasons. As loans default, they are typically removed from the
calculation of WARF and the Caa-Bucket, thereby, offsetting the effects of downgrades on non-defaulted
loans. Moreover, some managers are trading out of Caa assets for higher rated loans. Defaults, however,
continued to increase as Caa credits migrated to default. Conditional on credit markets’ liquidity continuing to
improve, we expect WARF and Caa Bucket levels to stabilize in the short term because of generally improving
economic conditions and existing Caa-rated assets defaulting, resulting in their removal from the indices.
Defaults, however, will continue to increase until the expected economic recovery takes effect.
CLO liability spreads have continued to narrow in June and July, although they are still much higher than last
year’s levels. The Aaa CLO spread is close to 450 bps in July, compared to 600 bps in May, but it is still higher
than the level of about 375 bps in October 2008. 3 This suggests that despite improvement in some of the CLO
metrics, concerns about CLO performance continue to overshadow the improved sentiment toward underlying
corporate credits.
The narrowing of CLO liability spreads is highly correlated to the improving leverage loan market. Although
the range is wide, average loan prices have returned to the 90s in the Ba category, compared to the 70s at the
beginning of this year. Prices for Caa loans were in the 40s at the beginning of this year, hit a low of about 36
in late March and are currently above 60. Loan price improvement has contributed to the better OC ratios in
recent months. Loan prices have become a more important within the calculation of the OC ratio as Caa and
defaulted buckets have continued to rise. ❖
3
“Securitized Product Round Table”, Citigroup Global Markets, Inc., July 20, 2009
The majority of the repurchase plans have involved senior-most tranches, although we have also seen
proposals for repurchasing other classes of notes. Some repurchase plans have been structured to use
principal proceeds while others rely on a combination of principal and interest proceeds. Typically, they also
specify a maximum repurchase price as well as a limit on the dollar amount of the notes eligible to be
repurchased.
Most repurchase plans involve a supplemental indenture that provides a framework for future repurchases that
could occur over time. A few are in the context of already existing provisions in the CLO indenture that allow
for note repurchases.
The following provides a summary of some of the questions and issues that have arisen as we’ve assessed
the impact of the proposed note repurchases on CLO ratings.
Sources of proceeds and portfolio quality: What are the sources of the proceeds that would be used to
fund the repurchase? Would interest proceeds be used? If so, from which step in the waterfall would
interest be diverted? If principal proceeds are to be used, are sale proceeds involved or would the
sources be limited to prepayments and amortizations? To the extent that the manager would be permitted
to rely on sale proceeds to effect a repurchase, we would be concerned about the motivations behind any
particular sales and the resulting effects on the quality of the remaining portfolio. If the assets to be sold
are identified, we can model their impact on the CLO; however, this is not always the case.
Priority of repurchased notes: Which class or classes of notes are being repurchased? If classes other
than the most senior could be repurchased, we would evaluate the impact on the ratings of the more
senior classes whose priorities effectively would be lowered. 4
Intra-class payments: Would the repurchase direct proceeds to only those holders whose notes are
being repurchased instead of to all the holders of a given class? We would be concerned if the
repurchase reduced the amount of proceeds distributed to investors not involved in the repurchase on any
given payment date.
Process of repurchase: How will the repurchase be conducted? Will all of the noteholders be notified
and provided the opportunity to retire their notes? Will only those holders whose notes are already
available for purchase in the secondary market be approached? Will the repurchases be conducted on an
arms’ length basis? We would be concerned if the repurchases occurred based upon the manager’s
solicitation of individual investors in a less than transparent process.
Repurchase period: Does the plan describe a single repurchase whose terms are explicitly defined? Or,
is it meant to facilitate an open-ended ability to carry out multiple repurchases? We would be concerned
about ongoing repurchases regardless of future CLO performance and market conditions.
Noteholder consent: Is a supplemental indenture being contemplated? If so, will noteholder consent be
sought? Even if noteholder consent is not required by the indenture, we may view the nature of the
amendment to be material enough that we would consider providing a rating agency confirmation only if
such consent is obtained.
4
Moody’s has seen some proposals to retire notes from classes other than the most senior using interest proceeds that would otherwise have been paid to
equity investors. Because such a retirement would increase the overcollateralization levels without repaying the senior notes, we would have to run our
ratings model to analyze the effect on the notes’ ratings.
Distressed exchange: Does the repurchase qualify as a distressed exchange? 5 Based upon its
specific details, we will evaluate each repurchase to determine whether it meets these conditions.
Given that each deal contains its own provisions and requirements, each plan is analyzed on an individual
basis. The above list contains some of the potential concerns that could arise in the context of a repurchase
and should be examined closely by the involved parties. ❖
5
Moody’s defines a distressed exchange as occurring when: 1) an issuer offers creditors a new or restructured debt, or a new package of securities, cash or
assets, that amount to a diminished financial obligation relative to the original obligation and 2) the exchange has the effect of allowing the issuer to avoid a
bankruptcy or payment default.
In some jurisdictions, including the U.S. (where issuers have asked Moody’s to consider the springing true sale
theory), there has been a legal concern that the underlying loans in a CLO are not actually transferred or sold
from a sponsor’s balance sheet to the CLO if the sponsor holds all or a material portion of the CLO liabilities
and equity. Typically, balance sheet CLO issuers in the U.S. try to sell a portion of the CLO capital structure
until reaching at least the minimum level at which legal counsel are willing to provide an opinion that a true
sale has been achieved. However, given current market conditions, this may not always be possible.
In a situation where the sponsor holds all of the CLO notes instead of the CLO selling them in the market, it
could be argued that the transfer of the loans to the CLO has been just a case of transferring the assets within
the same entity from one hand to the other. However, there are implications to the ratings on the CLO, which
are assigned on a stand-alone basis without regard to who the CLO’s sponsor was or its noteholders may be.
Until the liabilities are transferred and a true sale on the underlying loans is achieved, the ratings have to
capture the risk that the assets may not be available to the CLO, or the CLO may have only a limited interest
in the assets, under the scenario of the sponsor defaulting or becoming insolvent.
If the sponsor files for bankruptcy, the sale of the loans to the CLO is challenged and the bankruptcy court
finds there was no true sale, the loans would be viewed as part of the sponsor’s estate, never having been
transferred to the CLO. In that case, the CLO will have to make a claim against the bankruptcy estate and will
be at risk of sharing the value of the loan assets with the sponsor’s other creditors, which is a rating issue for
the CLO notes. If the CLO took a perfected security interest in the loans as a back-up to the true sale, then
the CLO will generally be entitled to have the value of the loans applied to its claim in the sponsor’s insolvency
proceeding, but it will have to successfully assert the priority of its claim and wait to realize this value. In the
absence of a security interest, the CLO’s claim against the sponsor will be unsecured and it will need to share
with other unsecured creditors in the sponsor’s remaining assets, which will be held by the sponsor’s
insolvency estate for the benefit of all its creditors. If this is the case, the CLO’s noteholders could lose their
entire principal investment, especially because the CLO would have no direct claim to the underlying loans. ❖
Ruth Olson
Vice President - Senior Analyst
+1 (212) 553-4092
During the second quarter, we downgraded 510 CLO tranches of 93 transactions totaling approximately
US$33 billion. Notably, 74% of the 180 Aaa-rated tranches that were reviewed during this period were
downgraded an average 3.6 notches (i.e. to between Aa3 and A1 on average). We also revised our outlook for
senior CLO tranches, and now expect a majority of CLO tranches originally rated Aaa may be downgraded in
the coming months. Most actions on Aaa tranches are likely to result in ratings in the Aa category, but actual
actions will of course vary from deal to deal.
Of the 510 downgraded tranches, 481 were from 89 U.S. CLO transactions totaling US$31 billion, with the
remainder originated in Europe. Downgrades affected 132 tranches (approximately 26%) that were previously
rated Aaa. Combined with rating actions taken in the first quarter, Moody's has downgraded 2,307 tranches
(roughly 48% of 4,762 tranches) totaling US$82 billion globally in the first half of 2009.
We note that CLO portfolios experienced significant deterioration in portfolio performance during the first half
of this year, although there were signs of stabilization in key performance metrics in May and June. In
particular, the average WARF increased by about 200 points from 2720 to 2918 in the first quarter before
improving slightly in June. The average proportion of Caa-rated assets in the portfolios rose from around 9% in
January to 12.6% in April and then declined to 11.9% in June. At the same time, defaults increased steadily
from 3% in January to 6.3% in June, while OC levels stabilized somewhat in May and June after suffering a
significant drop from January to April. This performance deterioration coincided with the deterioration in global
corporate credit, which has seen some of its worst performance in several decades.
We also observed that while CLOs overall have experienced significant deterioration, there are marked
performance variations across deals. In the U.S., for example, approximately 90 CLOs identified as high-
priority (called “Phase 1”) deals had an average Aa OC level of 114%. This compares to an OC level of 120%
for the remaining lower-priority deals to be reviewed in the coming months. This observation is leading us to
prepare for and expect potentially large variations in future portfolio performance among remaining deals.
Moody's plans to conclude its global CLO surveillance sweep by the end of 2009. ❖
Ramon Torres
Vice President – Senior Credit Officer
+1 (212) 553-3738
The typical CLO Issuer is a Cayman Islands entity. It is structured to be a bankruptcy-remote special purpose
vehicle primarily concerned with holding corporate loan obligations as collateral and issuing debt and equity to
investors. Payments are derived from the income stream generated by the collateral pool. The Issuer is also
intended to qualify under U.S. federal income tax rules that provide that an off-shore corporation will not be
subject to U.S. entity level tax on its net income if its activities are deemed as not being engaged in the
conduct of a U.S. trade or business.
As a rule, CLO Issuers are not permitted to form subsidiaries out of concerns that should its activities and
income be attributed to the CLO Issuer, it could threaten its bankruptcy-remoteness and/or its tax exempt
status. Similar concerns also prohibit CLOs from acquiring as a qualifying collateral debt security any asset
that may cause the Issuer to be engaged in the conduct of a U.S. trade or business for federal income tax
purposes. Equity positions in other entities (such as certain partnerships, grantor trusts and limited liability
companies) are typically not qualifying collateral debt securities. CLO Indentures therefore impose strict rules
about the acquisition and disposition of such interests.
The Tax Blocker is intended to strike a delicate balance. On the one hand, it tries to segregate in a wholly-
owned subsidiary the equity-like security that the CLO receives through a workout or restructuring, thus
hopefully removing the harmful tax consequences to the Issuer if the asset were to remain part of the collateral
pool. On the other hand, the transfer of the asset to the Tax Blocker, rather than requiring the CLO manager to
outright dispose of the asset at what would currently likely be depressed prices, allows for the asset to be held
so that income and gain may be realized as the asset appreciates over time.
In assessing a Tax Blocker’s potential impact on the ratings of a CLO, Moody's takes into consideration
various factors. These factors include, but are not limited to, the risk of CLO entity level taxation; the scope of
the Tax Blocker’s permitted activities; the way in which corporate separateness, bankruptcy remoteness, and
maintenance of a first priority perfected security interest in the collateral transferred to a Tax Blocker are
addressed; how expenses, taxes and other liabilities incurred by the Tax Blocker are satisfied; and in what
manner distributions are made by the Tax Blocker to the Issuer. ❖
Announcements
“Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (July 27, 2009)
“Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (July 20. 2009)
“Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (July 13. 2009)
“Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (July 6, 2009)
Publications
“Moody's Quarterly US CLO Report - Q2 2009” (July 31, 2009)
“Monitoring of Japan’s SME CDOs and Rating Outlook” (July 28, 2009)
“Structured Finance Ratings List: Changes & Confirmations” (July 23, 2009)
“CIT Impact on Cash Flow CLOs Expected to be Minimal (July 20, 2009)
“CLO Ratings Surveillance Brief: Second Quarter 2009” (July 17, 2009)
“Moody's Implements Changes in its Modeling Assumptions for Market-Value CLOs” (July 9, 2009)
“V Scores and Parameter Sensitivities in the Global Cash Flow CLO Sector” (July 8, 2009)
“Collateralized Debt Obligations Performance Overview Compilation Europe April 2009” (July 2, 2009)
“Collateralized Debt Obligations Performance Overview Compilation April 2009” (July 1, 2009)
“Moody's Deal Score Report CDO Deal Summary Performance April 2009” (July 1, 2009)
“Moody's View on Transferring Loans Using Participations in Lieu of Assignments in CLOs” (June 23,
2009)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication
of this report and that more recent reports may be available. All research may not be available to all clients.
Moody's Derivatives Group is the leading source for credit ratings and research on collateralized loan
obligations (CLOs), collateralized bond obligations (CBOs) and the entire structured derivatives market. The
CDO group leverages Moody's decades of experience in Bank Loans and High Yield as well as our-market
leading Default Studies to produce the most accurate rating methodologies for this asset class.
Editors
Robert Cox, Jeremy Gluck, Algis Remeza
CREDIT RATINGS ARE MOODY'S INVESTORS SERVICE, INC.'S (MIS) CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT
COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MIS DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL,
FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS
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