Moody's Investors Service last week released a report addressing the concerns it has with the loan-only credit default swap template dealers put together. Collateralized loan obligation managers interested in LCDS have, to date, held off from jumping in with both feet because they are uncertain how LCDS will play out in their portfolios and how the ratings agencies will view them. One portfolio manager interested in the product said his firm has just not figured out how exactly LCDS will work in a CLO and will not try to make it work until Moody's has addressed exactly how it will rate the product. In its report Moody's outlines its concerns relating to reference obligations, multiple currencies and the maturity of some swaps.
Rudy Bunja, a senior v.p. at Moody's, said it does not have in the pipeline any CLOs just using LCDS and the only inquiries it has received deal with how a synthetic CLO will employ the template. He said it will take time for the dealers to digest and see if and which suggestions it will adapt. He stressed the paper is not meant to offer any hard and fast rules, but rather to address some of the questions the ratings agency has. Members of the dealer group could not be reached for comment. Here's a quick breakdown of some of the key issues in the Moody's report:
The reference obligation. In the LCDS Template, the reference obligation must always be a syndicated, secured loan and unless the obligation category is defined as a reference obligation only, a credit event could be triggered by other obligations of that reference entity. Under Moody's current CLO rating methodology, senior secured loans are granted more favorable default probability/weighted average rating factor treatment than bonds and other non-senior secured loans, even if it is the same obligor. Moody's explains that even if the reference obligation is a senior secured loan, "if a non-senior secured loan or bond can trigger a credit event, the CDS may not be eligible for a pass-through of the senior secured loan default probability/rating factor."
One way Moody's suggests to mitigate this concern is to ensure that LCDS is physically settled as it currently is and that the delivered obligation is a senior secured loan that meets the CDO's collateral debt security eligibility criteria had the deliverable obligation been purchased at the time the LCDS is entered into. That way, even if a credit event is triggered by a default of the reference entity's unsecured obligations, if the delivered senior secured loan is performing, it can be held by the CDO as a performing collateral debt security and therefore it would not be classified as a defaulted.
Multiple Currencies. Moody's is also concerned that the current template allows loans to be delivered in a number of currencies, which could be problematic for some portfolios that can only invest in U.S. dollar-denominated securities. Moody's offers a number of solutions to this problem. The first suggestion is to remove from the specific LCDS agreement the ability for the buyer to deliver obligations in non-U.S. currencies, though the ratings agency said that could affect pricing and liquidity for the seller and create basis risk for the buyer. Another suggestion was to require cash settlement or immediate sale upon delivery of a non-U.S. dollar-denominated obligation.
Maturity. Moody's notes that the template allows a delivered loan to have a maturity of up to 30 years, which could potentially be a later maturity than the CLO. Because some CLO tranches can be very sensitive to even small long-dated baskets, Moody's factors this in when performing a rating analysis on a CLO. Moody's explained that this additional risk may be reflected in the rating factor or recovery rating assigned to the LCDS. It offers an alternative to the current language, which would alter the deliverable obligation characteristic so that the maximum maturity can only be as long as the maturity of the CLO.
