Ratings Reversals

Back in our December 2010 piece (The Psychological Biases of Holding Downgraded Bonds) we commented on what was to us a rather unusual trend in the collateralize loan obligation space, where these bonds were being downgraded at a time when their fundamentals were already (generally) rebounding.

“[One] rating agency began downgrading collateralized loan obligation (CLO)securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to 'normal' levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.”

Moody’s recently produced some very informative data on their ratings reversal rates in structured finance. Not surprisingly – at least to to us and the avid readers of our blog – CLOs lead the list of ratings reversals, at a rate of approximately 5 times that of other CDOs (excluding CLOs) and more than 6 times the rate of all global structured finance ratings provided by Moody’s.



The downgrading (if it is premature) of a long-term bond only to subsequently upgrade it falls broadly within what is referred to as a “Type II” ratings error.

Holding lower-rated bonds can be more expensive for investors. This may encourage holders to sell the bonds to the extent the cost of funding the lower-rated bonds is too high, or they may even become forced sellers to the extent the lower ratings fall outside of their investment guidelines or their vehicles’ eligibility criteria. Thus, in addition to the (rather unfortunate) increased cost of funding on a downgraded bond, one may be forced to sell the bond at an inopportune time, only to see the bond subsequently re-upgraded.

Ratings reversals can include downgrades followed soon after by upgrades, or upgrades accompanied by subsequent downgrades.

Examples of Moody’s ratings reversals:

1 - Gresham Street CDO Funding 2003 class B notes (CUSIP 39777PAB9): Originally rated Aaa in 2003. Downgraded (Moody’s) to A1 in Aug. 2009. Upgraded to Aaa in May 2010. (S&P maintained rating at AAA throughout.)

2 - Halcyon Loan Investors tranche B (CUSIP 40536YAJ3): Downgraded from A2 to Ba1 (March ’09) to B3 (June ‘09); upgraded back to Ba3 (May ’10) and Ba1 (Dec. ’10).

Happy Easter everybody!
- PF2

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For more on this topic, click here.

Marathon, or Just a Quickie?

Friday’s Asset-Backed Alert describes the (mildly fascinating) behind-the-scenes activities of Marathon CLO I, a 2005-vintage CLO managed by Marathon Asset Management.

According to the article, Marathon itself recently purchased most or all of its deal’s senior-most tranche from Bank of America, at prices purported to be in the 85 cents on the dollar range. To turn a quick profit on their senior note investment, Marathon swiftly sold off roughly two-thirds of the collateral underlying the CDOs, with the proceeds being diverted towards substantially paying down their senior tranche, at par. By our back of the envelope calculations, if Marathon purchased the entire tranche, they would have made a profit on this trade of roughly $26.75mm already, with potentially more to follow.

As far as we’re aware all of the deal’s par coverage tests (“OC tests”) declined between mid-September and mid-October, despite continued improvement in the market for leveraged loans, which support these CLOs.

Why is this Interesting?

(1) While Marathon may have benefited greatly from its extensive trading activity, all other noteholders are, at least in our opinion, worse-positioned for it: in a month in which most CLOs’ OC test ratios improved, all OC ratios of Marathon CLO I suffered, arguably purely as a result of their aggressive trading during this period.

(2) The substantial paydown of the Class A1 notes (CUSIP 565763AA7) might encourage Moody’s to upgrade the tranche from its current rating of A1, with a possible Aaa rating in sight.

(3) Managers are typically disincentivized from any earlier-than-necessary unwinding of their deals: the longer their deals run, the longer they continue to collect management fees for managing the collateral; however, in this situation, the upfront profit of say $26mm would vastly outweigh the potential additional revenue stream of less than $2mm per year that a manager may hope to earn in fee from managing a deal such as this. (Managers earn fees based on the size of the portfolio, so a paydown decreases future fee generation.)

(4) The spirit of the deal is that managers are supposed to manage “across the capital structure.” In other words, though very difficult, they’re supposed to make managerial decisions that are in the best interests of all investors of the deal, certainly not only the senior-most tranche holders. At the same time, the dynamic is that rating agencies are trying to protect their rated noteholders, but not only the senior-most holders. Though it’s an imperfect system, the collateral manager is often required to purchase some of the equity of its own deal, to ensure that it manages across the structure, thereby sending proceeds down the waterfall as far as the equity notes (see here for examples of how this structural nuance can be manipulated).

(5) In this scenario, largely as a result of the early liquidation of assets, most if not all of the other rated noteholders will suffer, which could bring the rating agencies’ ratings on these notes into question, and the equity holders likely lose any potential upside they might otherwise have hoped to gain on their investment.

(6) Aside from allowing “Credit Risk” sales, rating agencies try to protect against aggressive management by limiting the amount of trading activity permissible by a manager (see example language below). With Marathon posturing such a large proportion of these sales as “Credit Risk Sales” it really calls into question the definition of a “Credit Risk Sale” and the question of a manager’s ability to arbitrarily designate a sale as a Credit Risk Sale simply to allow for its effectuation. Given that they were able to sell these assets at, on average, over 90 cents on the dollar, can they really have been Credit Risky? Does Marathon know something about all of these loans that the rest of the market does not? Did they all just suddenly become Credit Risks, encouraging Marathon to liquidate them in the best interests of all holders, or is Marathon acting in its own capitalistic interests?

Example Indenture Language

ARTICLE XII

SALE OF UNDERLYING ASSETS; SUBSTITUTION

Section 12.1. Sale of Underlying Assets and Eligible Investments.

(a) Except as otherwise expressly permitted or required by this Indenture, the Issuer shall not sell or otherwise dispose of any Underlying Asset. Subject to satisfaction of all applicable conditions in Section 10.8, and so long as (A) no Event of Default has occurred and is continuing and (B) each of the conditions applicable to such sale set forth in this Article XII has been satisfied, the Asset Manager (acting pursuant to the Asset Management Agreement) may direct the Trustee in writing to sell, and the Trustee shall sell in the manner directed by the Asset Manager (acting as agent on behalf of the Issuer) in writing:

(i) any Defaulted Obligation, Credit Improved Obligation or Credit Risk Obligation at any time; provided that during the Reinvestment Period and, with respect to Defaulted Obligations and Credit Risk Obligations, at any time, the Asset Manager (acting as agent on behalf of the Issuer) shall use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount (A) with respect to Defaulted Obligations and Credit Risk Obligations, at least equal to the Disposition Proceeds received from the sale of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon), and (B) with respect to Credit Improved Obligations, at least equal to the Aggregate Principal Amount of the Underlying Asset that was sold; and provided further, that the Downgrade Condition is satisfied;

(ii) an Equity Security at any time (unless earlier required herein); provided that during the Reinvestment Period, the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets with a purchase price at least equal to the Disposition Proceeds of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon) received from such sale;

(iii) any Underlying Asset which becomes subject to withholding or any other tax at any time; and

(iv) in addition, during the Reinvestment Period, any Underlying Asset not described in clauses (i), (ii) or (iii) above, if (x) no Downgrade Event has occurred and (y) with respect to any sale after the Payment Date occurring in September 2012, the Aggregate Principal Amount of all such sales for any calendar year does not exceed 25% of the Portfolio Investment Amount; provided that the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount at least equal to the Aggregate Principal Amount of the Underlying Asset sold (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon).

UPDATE, November 20, 2009: This morning's Asset-Backed Alert edition suggests, quite disturbingly, that Fortress and TCW may be considering similar moves to that of Marathon, in their Fortress Credit Funding CLO and Pro Rata Funding Ltd. deals, respectively.

"and yes I said yes I will Yes."

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”

OUR OPINION

Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.

Liquidity

Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.


Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Anatomy of a Recovery

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.

The CLO Also Rises

The May/June rally and subsequent stabilization of CLO tranche values has shown us that despite times of deep distress, culminating in loan downgrades and defaults, CLO managers on average have been at least temporarily able to build OC coverage. In sum, the par they were able to gain by way of their discount purchases, together with loan price appreciation and the ability to offload certain CCC assets, served as a greater combined force than the dual impositions of portfolio downgrades and defaults.

But one other item has become more readily apparent since May: that investors are increasingly differentiating between AAA CLO tranches (or, at least, between what were originally AAA CLO tranches), resulting in their trading within a wider bracket. As we shall see, not all AAA CLO tranches were created equal.

The complexities in evaluating CLOs, or even CDOs in general, are not limited to making long-term assumptions on a potentially dynamic, managed pool. Nor are the complexities limited to the modeling of each deal’s intricate structural features, such as pro-rata sequential paydowns or BBB tranche turbo features. The language of the indenture – the CLO’s governing document – brings with it a host of nuances in interpretation.

Our most recent piece explores one of the more timely nuances: the varying natures of CCC-rated loan haircuts.

The full report can be read here: Special Report: CLO CCC Buckets - Key Variations in Terms and Performance

An excerpt from the piece:

"... an investor looking for exposure to a CLO that does not have aggressive deleveraging provisions would want a CCC bucket has some or all of the following features:

- is as large as possible (at least 10%);

- references Moody’s loan rating not CFR in determining which securities are in the CCC bucket (and that has as “flexible” a definition of Moody’s rating as possible);

- includes only purchased CCC securities in the CCC bucket;

- haircuts excess CCC securities to MV (with as “flexible” a MV definition as possible);

- is ambiguous on which securities fill the bucket first (or even allows low MV securities to fill first); and,

- diverts cash‐flow for reinvestment and never for deleveraging.

In contrast, an investor looking for exposure to a CLO that has aggressive deleveraging provisions would want a CCC bucket that has all of the following features:

- is as small as possible (no more than 2.5%);

- references Moody’s CFR and not Moody’s loan rating in determining which securities are in the CCC bucket (and that has an “unambiguous” definition of Moody’s rating);

- includes all CCC securities (including both purchased and downgraded CCCs) in the CCC bucket;

- treats excess CCC securities the same as Defaulted Securities and haircuts them to the lesser of MV and recover value (and that has a strict definition of MV);

- clearly fills the CCC bucket with only the highest MV securities first; and,

- diverts cash‐flow for deleveraging only and not for reinvestment."

The KYSS Principle

We're coining a new phrase on this bright-n-sunny summer morning:

KYSS - Know Your Super Senior

Or Know Your Senior Secured. Either way, knowing who's above you in the capital structure can be immensely useful, particularly in the world of defaults.

We've been seeing this in ABS CDO space for a while now, as the contrasting interests and demands of the controlling class holders have determined whether defaulting CDOs were liquidated or accelerated.

And we recently spoke about this in the leveraged loan world too (click here for the full transcript) where banks and CLO managers have possibly different agendas in the corporate loan amendment process:

The big difference is when banks are the lenders the relationship between the borrower and the lender often goes back many, many years and may include businesses like bond underwriting and cash management and other types of solutions that the banks offer. And so the banks are going to be even more incentivized than usual to grant covenant relief and find a solution that allows for continued revenue generation. With institutional investors, on the other hand—and we’re talking CLOs, prime rate mutual funds and the like— they’re “transactional lenders.” In other words, their relationship doesn’t go any further back than the individual loan in question here and so their incentives will be naturally more immediately self‐serving.

Thus, as a prospective subordinated bondholder (i.e., purchaser) it might be wise to find out who is holding the senior secured loan. What would the amendment process look like? What sort of acquisition restrictions will be imposed on the borrower post amendment, and amendment fees and charges will leak to the senior lender. (See for example Richard Kellerhals' recent piece Investors Fume as Banks “Extend and Pretend.”)

So go ahead and KYSS - it may even change the way you see the bond you currently hold.

Collateral Managers and Takeover Opportunities

Collateral managers banding together...here's a link to the report we sent out last week. Enjoy.

Collateral Managers and Takeover Opportunities

From Lemmings to Lemons

"The market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them." - Avinash Persaud, April 2008.

This quote came to my attention via Felix Salmon's Market Movers via Reuters, and it encouraged me to develop our thought process from an earlier piece we put out, entitled Static Measures for a Dynamic Environment.
The point: in a changing environment, one has to proactively adapt modeling assumptions (such as recovery rates and correlations) to reflect those changes.

As Operation Securitization got underway, escalated and then came to an abrupt, sudden halt, each input into the model needed to have been updated due to the gargantuan size of the market -- and its subsequent influence and impact on trading levels -- and the systemic risk is brings with it. For example, the growth of the collateralized loan obligation market (CLOs) from 2001 through 2006 continued hand-in-hand with the growth of the leveraged loan market. With CLOs constituting the majority of demand for these (typically broadly-syndicated) bank loans (roughly 60-65%) the demand base grew in tandem with the supply source. But we saw no adjustment in either recovery rate assumptions (for loans or CLO-issued notes) or in correlation (between loans and CLOs or between loans or between CLO tranches) on the basis of, or necessitated by, this dual, dependent growth.

Surely if the CLOs stop buying, with the demand source halted, loan recovery rates must plunge downwards. And that's what's happened. Indeed performing leveraged loans have recently oscillated between trading levels of 50% and 65%, well below historically realized recovery rate levels for defaulted corporate loans! (70-80%)

We've described this phenomenon in more detail in The Corporate Loan Conundrum. Also, The Elephant in the Room describes our astonishment that certain recovery rate estimates to this day remain unchanged.

The system-wide (systemic) mass-production of securitized tranches helped undermine the value of each in the crisis. The greater the supply, the lower the recovery when things don't work out, and the more correlated they become. And so the banks -- the lemmings -- acting in unison for the most part, created lemons (there are notable exceptions who are still around).

Separately, while my "lemons" are securitized tranches, Brad Setser took the initiative back in 2007 of Turning lemons into lemonade. His lemons are different: they are mortgages; his lemonade being securitized notes.

His article is thought-provoking for many reasons. Here are two: (1) it brings to the fore the economic principle of lemons (think second-hand cars), a principle which relates nicely to the government's purchasing of "toxic assets," and (2) it reminds us of the correlation question: increased correlation improves the quality lower tranches. Why, then, in this market of increased correlation, are the lower tranches of securitized notes not being upgraded? Well, it's a loss-loss scenario for them: correlation, like volatility, increases precisely in the tough times, during which defaults are high. During these times the lower tranches die a quick or slow death in any event, depending on the deal. Superfluous then?

The Corporate Loan Conundrum

Here's our two cents worth on the year-end state of the leveraged loan market, and a little insight into the challenges that lie ahead.

First off, 2008 was a tough year for corporate loans. Among leveraged loans, we saw roughly 4.5% to 5% defaults for the year, heavy pricing declines (the S&P/LSTA U.S. Leveraged Loan 100 Index was down roughly 30% in '08) and with them low recoveries, due, among other things, to the supply/demand problem and pessimistic perceptions for the economy.

(Worth pointing out was a slight uptick in the second half of December. Was this a bottoming out? A false bottom perhaps? Some high-level executives and managers are vocal about current spread levels being at or near their highs, and that we're due for some tightening in 2009. See for example Creditflux's Viewpoint: Looking for the bottom; but are they talking their book, and do we really have a good feeling for the duration of loans in this low, slow prepayment environment?)

An Issue of SUPPLY (and demand)

Demand is so small is deserves only a side mention; supply is the elephant. Why?

1. Fund (incl. hedge fund) liquidations and forced selling, to meet both investor redemption requests and (particularly variation) margin calls
2. Selling by banks to decrease leverage
3. Overhang of unsold loans (incl. bridge loans) on syndication desks' balance sheets that the banks were no longer able to securitize due to the severely diminished CLO juggernaut, a previously major source of demand for broadly syndicated loans
4. Demand by existing CLO managers has decreased too:

• low prepayments on current loans in the portfolio mean less available principal to reinvest
• loan downgrades have resulted in many CLOs maxing out on their CCC-rated buckets (which in turn limits managerial flexibility in trading new loans)
• historically low loan prices mean that investments in these loans are reflected as "deep discount" purchases for overcollateralization test purposes

What the future holds for loans and CLOs

Corporate loans weren't highly traded, relative to bonds, say, prior to the onslaught of CLOs (which steadily gained steam from 2001 to early 2007). S&P/Markit/Reuters' move towards a CUSIP identifier (from LoanX, LN numbers) may prove of minor assistance to the liquidity situation, but this will take a while.

The prospects are dim for 2009: large supply and high defaults are typically accompanied by low recoveries, a dual burden (see for example Longstaff, Schwarz's "A Simple Approach to Valuing Risky Fixed and Floating Rate Debt").

As this relates to CLOs: as defaults continue to plague corporations and deals continue to fill their CCC buckets -- and then have excess CCC assets haircut at market value (not recovery rate) for overcollateralization test purposes -- more CLOs naturally begin to trip overcollateralization triggers on a weekly basis, causing cashflows to be directed from the junior tranches and residual pieces towards paying down senior note holders (reducing the duration of the latter).

Similarly detrimental is the fact that most CLOs ramped up their loan portfolios during a credit cycle marked by the particularly high levels of liquidity it generated and the low defaults exhibited. The resulting strong demand created the opportunity for debt issuers to obtain low coupons on their debt despite weak covenant packages. Strong covenant packages typically reduce a company's cost of debt and, importantly, protect debt investors from wide negative swings in the value of their investment. (In sum, relative to a company's overall investors, weak debt covenants are arguably equity-friendly for the company, and debt-unfriendly.) See also The Luxuries of a Covenant Light Lifestyle.

The optimistic view is that this can all change quickly if we begin to see sufficient buyer power at these distressed levels. If some of the distressed funds decide that the opportunities lie in loans, and the bigger loan/asset managers (PIMCO, Babson, TCW, Blackrock) start putting their money to work, loan prices could rebound even on thin volumes and the deals which have benefitted from decent excess spread generation over the last 4 to 5 years during the low default environment may survive some of the pending difficulties. Certainly we're optimistic that many, if not most, of the AAA tranches will come out whole in this scenario, but whether the AA or single A tranches survive or suffer principal losses may differ from deal to deal, and may depend on the remaining length of each deal's reinvestment period, among other things.

While we fear the worst, we're long optimism.

Opal CDO/Structured Products Summit

We came down to sunny southern California for the Opal Financial Group Summit which ended yesterday and thought we'd relay some of what was spoken about.

To be fair, despite the lush greens of the Dana Point resort town, the attendees were rather bleak about what the future holds, in terms of the resurrection of the structured finance market in general, the calling of the "bottom," expected future recovery rates, and the foreseeable issuance (or lack thereof) of new issues to the market in general and particularly relating to residential and bank loans.

Across the board, panelists expressed their views that 2009 would be a very tough year. Wide-spread pessimism as to the leveraged loan recovery rate future relative to other historically difficult times, with Four Corners' Michael McAdams being the notable exception, expecting 1st lien recoveries above the 50s to low 60s region, particularly for good managers who are able to hold on to the loan for a while post default.

On the economic side of things, from the panels and from discussions we had with market participants, almost nobody was confident in the government's effectuation of the Troubled Assets Relief Program (TARP) and almost everyone was opposed to the automakers' bailout. There was less talk about the covered bond market alternative to securitization than we would have expected ... perhaps alternative lending forms and mechanisms are in developmental stages behind the scenes to repaint the unfairly blemished face of the securitization industry. We'll share our views on the covered bond market shortly.

To end on a positive note, traders were seeing increasing trading levels over the last month, and expect this to continue through year-end at last, as (often newly-funded) opportunistic and distressed funds have begun to put their capital to work.

Is this a (permanent or temporary/false) bottoming with technicals matching fundamentals, or simply an end-of-year rebalancing and maneuvering of balance sheet assets and liabilities for fiscal year-end accounting and audit purposes?

The Luxuries of a Covenant Light Lifestyle

Blackstone president and COO Tony James wrote a piece for the Financial Times this morning touting covenant light loans as a "positive development," allowing companies "the flexibility to work through their problems and, thus, help maximise total enterprise value."

When a business hits a downturn, because of either poor management or external forces, you want the business to continue. An ongoing business has a far greater total enterprise value than one liquidating. Loans with strict covenants can destabilise an otherwise healthy company, when even a short recession over a few quarters might trigger defaults. The holders of the senior debt take action; cash flow stops to the junior debt, suppliers stop shipping, customers flee and employees lose jobs. The equity holders with little or no remaining stake in the business not only find it difficult to restore health to the business, but they have no economic incentive to do so.

Equally important is the value destruction that ensues when a company defaults. Creditors squabble and courts hold interminable hearings. In the meantime, the company drifts. The very worst time for a boat to lose its pilot is during a storm. But this is exactly what results from the traditional hair-trigger covenants that many see as the healthy formulation of leveraged capital structures.

All valid points, perhaps. But let's dig a little deeper...

Typically, the two pertinent loan covenants are incurrence and maintenance covenants. Incurrence covenants restrict the company's ability to issue debt (typically, senior to this loan - which makes sense, especially if you're the lender and wish to retain your level of seniority). Maintenance covenants describe (minimum) collateralization levels (think coverage ratios) that must be maintained to avoid the loan from being in default. When you speak of covenant light loans, you're primarily talking about loans who lack the maintenance covenant(s). The fewer the covenants, the lower the likelihood of default, and hence Mr. James' rosy article.

Now let's consider covenant light loans as a microcosm for today's environment. Everybody's long regulation. Regulation is king. The market has seen what happens without it, and decided that it prefers regulation. Let's examine the lack of restriction (as a metaphor for regulation) on covenant light loans. The covenants act as a means for the lender to involve itself (think govern or regulate) in the performance of the company if/when it fails to comply with its covenants. Among other things, the lender can extract additional spread from the failing company (as an alternative to enforcing default) or, upon default, the lender at least has a strong position at the negotiation table, as a senior secured lender, and since the only-recently-failing maintenance coverage ratio describes the company's ability to "cover" the loan, the lender often walks away whole, or at least close to whole.

In the absence of such a covenant, the lender has limited recourse until default. Granted that defaults are less likely, but once they occur, who is to say what the recovery rate may be?

In summary, if I'm borrowing, I'm long the additional flexibility (unless it costs much more); but as a lender, one has to expect that the severity of any defaults will be sharply higher than those having quality/coverage controls in place. This is the real downside that should be guarded against: lenders with large exposure to low-recourse, low-recovery loans which are or may defer interest or "pay-in-kind."

JPMorgan vs. Morgan Stanley

As an update to yesterday's piece, just to be fair to all parties involved, JPMorgan today stated they're newly bearish on AAA CLOs. Morgan Stanley yesterday described their bullish stance, saying that AAA CLOs could survive 10% CADR at 50% recovery rates. JPMorgan contend that widening is likely given the deep repressionary risk which will take its toll.

We'll keep you posted, but just a note that from an analytical perspective, unless (and this is a key "unless") the AAA tranches attaches (i.e., suffers any principal writedown), the value of the tranche will likely be higher for more severe default rate environments, as O/C trips will speed up payments to the AAAs. The shortened duration, then, improves the value when discount rates (DMs) -- as they are -- are higher than the promised coupon/spread on the tranche.

Are AAA CLOs "Safe?"

There's been a fair bit of structured finance research this month discussing, and mostly touting, the merits of investing in AAA CLO paper, which has been caught up in the generally widening market trend (currently trading around LIBOR + 475 bps).

For the most part, we expect the better cash CLO AAAs to avoid principal writedowns; generally, the underwriting standards for CLOs have improved over time, unlike their ABS CDO counterparts. Of course, the synthetic (LCDS) CDOs backed by senior secured loans (note: reference obligation is borrowed money) were not as fortunate. Many of these deals entered into an Event of Default upon Lehman's bankruptcy filing. See our prior pieces on Investigating the GIC and Eligible Investments for more on this.

For the leveraged/mark-to-market investor, we show a graph of the DM movement over the last 10 weeks -- based on just over 300 bid, offer and transactional data points since 07/31/08 -- and let you decide for yourself whether we're at the bottom:

(Click on it to enlarge the picture)