Moody's Investors Service has called in true sale collateralized debt obligation managers to talk about leveraged interest-rate instruments, know as inverse floaters, which it believes may have been purchased without authorization. Inverse floaters are attractive in low interest-rate environments as they pay high leveraged returns. If rates, rise, however, the downside is also leveraged. In a typical inverse floater the coupon decreases as rates increase and vice versa.
Mark Froeba, v.p. and senior credit officer in New York, said Moody's only recently noted the presence of inverse floaters, which in one deal accounted for as much as 5% of the portfolio. The assets can be difficult to detect because they are not explicitly listed. Red flags, however, were raised when it saw floating rate assets paying an unusually high spread. Froeba declined to name specific deals in which the notes have been detected.
CDO managers have told Moody's that inverse floaters are not expressly prohibited and are therefore allowed. Froeba disputes this logic. Moody's is firstly asking managers to explain why they believe the CDO indentures permit inverse floaters and is determining how to proceed based on their responses, said Froeba. It is too early to determine the outcome, although he noted that if the floaters remain in CDO portfolios they may affect deal ratings.
While the ratings agency does not intend to forbid the purchase of floaters, Moody's is concerned that they have been bought by managers opportunistically and were not envisaged at the outset of the deals. Moody's wants inverse floaters forbidden unless they are listed as a potential investment.
