Many collateralized debt obligations are structured to experience an event of default when a minimum overcollateralization ratio for senior liabilities is not maintained. In general, if the defined measure of the par value of assets falls below the face value of senior liabilities, an EOD occurs, allowing senior investors (frequently defined as the controlling class) to take control of the CDO. Upon the occurrence of such an event, senior investors may choose to accelerate the maturity date of their notes, liquidate the assets of the CDO or allow it to continue operating as before.
Many CDO transactions that have OC-linked EODs also include rating-based par haircuts in the calculation of the aggregate outstanding par amount of the underlying assets. Consequently, downgrades of collateral assets such as residential mortgage-backed securities and asset-backed securities CDO tranches may trigger EODs. In this report, we explain the following:
* The inclusion of rating-based par haircuts in the calculation of the aggregate outstanding par amount of the underlying assets increases the likelihood that the related OC-linked EOD will occur; whereas downgrades of assets in the underlying collateral pool is unlikely to cause an OC-linked EOD in transactions where rating-based par haircuts are delinked from the calculation;
* OC-linked EODs that have occurred in the past, primarily in collateralized bond obligations and some early vintage ABS CDOs, have rarely led to collateral liquidation;
* The likelihood that senior investors will liquidate the transaction depends on a number of factors, including the perceived economic benefit of liquidation; investors that use mark-to-market accounting may be more likely to favor liquidation than other investors.
Par haircuts in OC calculation and EOD triggers
Typically, cash flow and hybrid CDO transactions are structured so that when overcollateralization ratios are not maintained, cash flow is diverted from equity to senior tranches. The OC triggers are meant to function as structural protections for the note-holders against credit deterioration in the underlying pool of assets. Typically, tripping an OC trigger precedes the occurrence of an EOD and serves as an early warning sign for investors to assess the well-being of a given CDO transaction. Transactions without standard OC triggers may, nonetheless, include OC-linked EODs.
Several years ago, CDOs began to incorporate various par haircuts for assets that were either purchased at a substantial discount or that were rated, or downgraded, significantly below the average rating of the collateral pool. Moody's supported the use of par haircuts in CDOs as means to capture the potential credit deterioration in the underlying assets and to reduce the incentive for collateral managers to enter into par-building trades with the intent of avoiding the impact of standard OC tests.
In some cases, rating-based par haircuts apply to "excess" concentrations of assets with ratings below a specified threshold. In a high-yield CBO or CLO, for example, the haircut may apply to Caa-rated assets in excess of 7.5% of the aggregate outstanding par amount. In others, the haircuts may apply to all assets rated below a specified level. In transactions structured with higher average ratings -- e.g., ABS CDOs -- the haircuts would typically take effect at higher rating levels. For example, the haircuts may apply to all non-investment-grade assets in the collateral pool.
The severity of the haircuts also typically varies based on rating level. For example, in a mezzanine ABS CDO, the haircuts have usually been 10% for Ba-rated assets, 20% for B-rated assets and 50% for Caa-rated assets.
Historically, Moody's did not support the inclusion of rating-based par haircuts in OC-linked EOD triggers. In our opinion, the purpose of rating-based par haircuts was not to cause an EOD but to protect all investors by deterring par-building trades and by accurately reflecting the credit quality of the underlying assets. Nevertheless, numerous underwriters have included rating-based par haircuts in the calculation of EOD triggers purportedly to accommodate the concerns of senior investors.
Subprime RMBS and CDO downgrades trip some EOD triggers
The scope and magnitude of recent RMBS downgrade actions taken by rating agencies has magnified the impact of rating-based par haircuts on OC-linked EOD triggers. Moreover, ABS CDO downgrades will have additional impact on these calculations.
Accordingly, it is more likely that OC-linked EODs will occur in transactions where the senior OC threshold is calculated using rating-based par haircuts. On a transaction-specific basis, whether or not an OC-linked EOD threshold is breached will depend on (i) which senior classes are included in the calculation of the denominator (for example, only the super-senior Aaa, all Aaa-rated tranches or also the Aa-rated tranches), (ii) the exact OC threshold (e.g., a value of 1.0), (iii) the inclusion or exclusion of the par haircuts (rating-based or otherwise) in the numerator and, (iv) the current composition of the collateral pool.
To liquidate or not to liquidate
Moody's cannot predict the response of senior investors who constitute the controlling class in ABS CDOs to the occurrence of an OC-linked EOD. Once a CDO triggers an EOD, including an OC-linked EOD, the remedies vary from transaction to transaction. Typically, there are three courses of action available to the controlling class: (i) take no action and continue to receive principal and interest payments in accordance with the priority of payments ("waterfall"), (ii) accelerate the maturity date of the notes they hold, or (iii) liquidate the underlying assets of the CDO. The proceeds from the liquidation would be used to pay down the notes held by the senior investors.
Historically, OC-linked EODs have occurred in a number of CDOs, almost exclusively in connection with the spike in high-yield bond defaults over the 1999-2003 period. Despite the breach of the OC-linked EOD triggers in some high-yield CBOs and early vintage ABS CDOs, senior investors rarely chose to liquidate the underlying assets. Instead, the transactions continued to operate on a cash flow basis, with inflows from the assets diverted to the senior tranches in accordance with the standard OC mechanisms set out in the waterfall in the relevant indentures. Thus, the occurrence of an OC-linked EOD had little or no impact on these transactions.
The most likely explanation for why liquidation was not chosen is that the note-holders believed that the sale of assets in a depressed, illiquid market would realize unacceptably low value for the collateral. They evidently concluded that their returns would be higher (in some cases, less negative) if the CDO continued to operate on a cash flow basis instead of engaging in a "fire sale" of assets.
Investors who mark transactions to market, however, may prefer asset liquidation. In theory, because these investors already reflect the market value of their positions on their books, they may be less sensitive to the realization of possible losses. In reality, however, they may be unable to confidently mark their positions to market in times of extreme illiquidity. In any case, even if current marks are consistent with the investors' expectations of the proceeds of liquidation, investors may nonetheless believe that current prices are unreasonably low in a distressed environment and that better value may be achieved by continuing to hold income-generating assets.
In CDOs with "super-senior" classes, the super-senior investors frequently represent the controlling class following an EOD. In the past, many of these positions have been held by "buy-and-hold" institutional investors, monoline insurers, or occasionally underwriters who hedged their exposure with third parties outside the transaction. Monoline insurers who guarantee CDO obligations through a financial guarantee are not required to mark their exposure to market. However, where a monoline insurer is holding a super-senior position through a derivative contract outside the transaction, market value considerations may become one of the factors that influence their decision as to whether to liquidate.
In addition, as monoline insurers have become more cautious about increasing CDO exposures, these super senior positions have often been retained by the CDO underwriters who were not able to hedge their credit risk with a third party. These underwriters typically have to mark these positions to market. To the extent that these have been unfunded positions, the underwriters may have less incentive to accelerate the maturity of the notes and to liquidate the underlying assets because they would not benefit from such sale of the assets. However, underwriters with funded positions may be more likely to force liquidation.
Of course, there are reputational risks for parties who act in a manner contrary to the interests of more junior investors, especially in cases where the underwriter is the controlling class and the party that structured the deal with rating-based par haircuts in the OC-linked EOD calculation. Also, underwriters holding super-senior positions who are able to mitigate their economic risk by hedging these positions through a combination of index trades and credit default swaps have less of an incentive to liquidate.
Moody's current actions
Moody's is closely monitoring the senior OC values of CDOs where the calculation of aggregate outstanding par amount may be affected by downgrades of subprime RMBS and the resulting downgrades of ABS CDO tranches.
To date, several CDO transactions have triggered an OC-linked EOD. Upon receipt of the notice of default, Moody's identifies the remedies accorded to note-holders in the transaction documents and assesses the likely rating impact of potential courses of action. As part of this process, Moody's contacts the trustee, the underwriter, collateral manager and, to the extent possible, the senior investors representing the controlling class, of the relevant CDO. If notified of intent to liquidate, Moody's may perform a market value analysis of the underlying assets along with the analysis of the related hedging mechanisms.
This week's Learning Curve was written by Lina Kharnak, senior analyst, and Stephen Lioce and Teresa Wyszomierski, senior credit officers at Moody's Investors Service.