Recent Highlights from Total Securitization

Abstract

An unprecedented number of collateralized debt obligations will hit their events-of-default triggers as a result of massive downgrades by Moody’s Investors Service. Over the next 12 months, as many as 20% of the 2006 and 2007 vintage structured finance CDOs could hit EOD, said David Yan, head of CDO research at Credit Suisse. Last Thursday, Moody’s downgraded $33.4 billion subprime first-lien residential mortgage-backed securities. Another $23.8 billion of the bonds were placed on review for possible downgrade. The downgrades rocked the market not only for the sheer notional value of the bonds affected, but also for the severity, with about 32% of the downgraded Baa bonds falling to Caa or below. Events of default can be triggered for a variety of reasons, including inadequate overcollateralization coverage, willful violation of a covenant, and interest shortfalls to the AAA investor. As a result of hitting the EOD, the controlling classholder—typically the super senior investor—will likely choose the acceleration of all the notes, which become immediately payable and due. Also, any reinvestment period would be terminated, making the deal static. Yan noted that how that plays out depends on the transaction’s covenants and liquidation waterfall, unique to each deal. Analysts at Derivative Fitch said the rating agency had already received an event of default notice on at least one structuredfinance CDO and “expects more deals to declare EODs as the underlying collateral continues to deteriorate.” In contrast with the large number of EOD notices expected now, only roughly 12 notices were received on 2000, 2001, and 2002 vintages, which suffered from the inclusion of such collateral as manufactured housing and franchise loans, Yan said. High-grade ABS CDOs will be particularly hard hit as their senior tranches have thinner subordination levels, about 20% versus 50% for mezzanine deals. At the same time, they have larger buckets for other CDOs: 25% compared with 10% for mezz deals. CDO squared will be affected even more severely. “It’s hard to see how any part of their portfolio could escape unscathed,” said one investor. As banks race to calculate how close their CDOs are to EOD, the question becomes how the controlling classholders will react. One investor noted that the controlling interest could choose to liquidate the portfolio quickly, which would leave them open to heavy mark-to-market losses. One broker dealer has reportedly disseminated a letter notifying investors that it may Recent Highlights from