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Late last month, New Amsterdam Capital invited investors in three of its Mercator CLOs to meetings in London’s Canary Wharf. The asset manager made those assembled a seemingly innocuous proposal, asking permission to change the definition of deeply discounted assets in a market where almost all loans trade below 80. But the senior-most note holders in the CLO turned the request down flat.
As loan default rates spike, increasing numbers of CLO managers will ask AAA bond holders to amend indentures to build par by allowing them to divest toxic assets without taking haircuts against overcollateralization (OC) tests. They will likely fair no better than Mercator, according to various CLO investors, ratings officials and managers. The incentives for senior note holders to block any such changes are compelling: greed and self-preservation.
“The AAA investor only cares about whether he is made whole or not,” said one buyside CLO analyst.
CLOs want to substitute higher quality – and higher priced – loans for some of their riskier holdings but those trades would trip (OC) triggers in most indentures. AAA investors oppose amending the deep discount thresholds in their indentures that prevent the CLOs from reallocating without breaching the tests. That’s because the triggers protect the senior class by cutting off payments to junior investors and upstreaming all cash flow to the top of the CLO capital structure.
The amendment battle is the first salvo in what could be a drawn-out war between managers struggling to keep their deals in compliance with various triggers and AAA investors happy to see cash flow cut off to the rest of the deal, the sources said.
Game theory: Survival of the senior
Mercator could water down its amendment proposal and re-approach investors but has not yet decided to do so, said a source close to the deal. Noteholders for another Mercator CLO were scheduled to meet yesterday to vote on a similar measure, according to filings on the Irish Stock Exchange.
As initially tabled, the amendment would allow New Amsterdam to sell loans at prices of 65-80 without having to treat the sale as deeply discounted. The amendment would also change the definition of a senior loan to permit the manager to purchase senior unsecured loans in addition to senior secured loans, among other things.
But multiple CLO investors interviewed by Debtwire and sources tracking the amendments said that they don’t expect any deep discount amendments to pass.
If the amendments don’t pass, managers’ hands will remain tied by trading restrictions under the deep discount rule. The term deep discount obligation refers to assets that are purchased by a CLO at a price significantly below par and are generally defined as loans purchased below 80% of par regardless of rating or loans purchased below 85% of par if rated below B3.
The rules as they currently stand limit deep discount purchases by requiring a CLO to account for them at their purchase price for the purpose of calculating overcollateralization ratios. If these OC tests are triggered AAA holders can vote to accelerate, effectively cut off cash flows to all junior note holders. Eventually, liquidation could be an option.
Rating agencies have been swamped with amendment requests in recent weeks because under certain indentures the agency has to provide an opinion that downgrades won’t directly follow as the result of the change to the deep discount rules, said two rating agency officials. The amendments are coming from both European and US deals, one official said.
The dynamic between investors in the CLO market is reminiscent of the wave of accelerations and liquidations that hit ABS CDOs at the start of the credit crisis. A slew of AAA investors opted to liquidate the transactions at a loss – continually depressing the price of the underlying collateral and wiping out returns for subordinate investors. But CLO’s will be less likely to liquidate in the near term, primarily because the AAA class is not always the only class required to vote in favor of a liquidation.
The primary concern keeping AAA noteholders from loosening deep discount language is that the amendments would let managers use substitutions to cushion subordinate tranches, allowing excess spread to be released to the equity, said a ratings agency official, a CLO manager and a CLO investor. CLO managers are already sniffing around DIPs and exit financings for higher prices in an effort to stay afloat and boost their equity coupons.
Under rules issued by Moody’s Investors Service in 2004, the agency laid out price, rating and concentration limits it believes are sufficient to keep the deals’ ratings intact in the event of deep discount substitutions. Not all amendments are voted upon by noteholders and are instead recommended to the trustee, said a CLO manager and a second rating agency official.
AAAs look “money good” even as EOD triggers loom
The dominant position AAA notes hold in the competition for cash flow has attracted investors to the super senior portion of the capital structure. But below AAs, investors are generally hesitant to buy as CLO losses are widely expected to ultimately creep through the A tranche and above as loan losses mount.
This bifurcation in the market is priced into notes across the capital structure with AA notes trading around 10 points and single As quoted in single digits , while AAAs trade at around 550bps discount margin “money good”, as previously reported. The discount margin is the discount from par plus the coupon.
New entrants to the market - primarily hedge funds and less traditional bank holders – have sparked a mini-rally from discount margins of around 1000bps/1200bps several months ago, said a buyside CLO investor. He added that finding a motivated seller is difficult at this point as investors prep to reap the benefits of their senior position.
Expectations that default rates on deals will hit 7%-8%, thereby cutting duration, have also boosted expected returns on principal.
However, unlike the ratings-based ABS CDO liquidations, CLO event of default (EOD) triggers are most likely to be hit by a combination of ratings and actual loan performance, according to a report published by Wachovia 4 March. Not all CLOs discount CCC rated loans, and overcollateralization triggers vary for senior tranches.
Depending on the timing of corporate loan defaults and downgrades, most CLOs will hit EOD triggers in the first quarter of 2010 through mid-year, the Wachovia report states. Outstanding CLO senior tranche OC levels currently average 120%-125% - leaving a 20%-25% cushion before most EOD triggers are sprung, the analysts wrote. The most senior classes have lost about 5% of OC at this point, according to a CLO trader and an analyst.
Early warnings tests have already been tripped. Around 50% of outstanding CLOs are breaching their most junior interest diversion tests, according to a second analyst’s estimates. Around 30% of deals have already shut off payments to the equity coupon.
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