A recent watchlisting of a trust preferred collateralized debt obligation turned out to be a false alarm because one of the underlying obligors in question had resumed paying cash flows to the structure.
The case is noteworthy because it raised a red flag on the growing $20 billion trust preferred CDO market, which has benefited from a perfect track record. In fact, the Moody's action marks the first time such a deal has been put on watch and no trust preferred CDO has ever been downgraded. That's no small feat for the CDO market, which has seen more than its share of downgrades, according to one CDO veteran. He said trust preferreds' main appeal as collateral is the diversity and stability they offer.
Moody's Investors Service took the notes of Regional Diversified Funding, which was the first such CDO sold and closed in March of 2000, off watch for downgrade late last month after one of the mid-sized banks in the deal resumed paying cash flows to the vehicle. Jim Leahy, v.p./senior credit officer, explained Moody's put the bonds on watch because a second obligor in the deal started to defer its payments. Moody's soon after took the bonds off watch after it discovered the original tardy borrower had sought regulatory approval to resume making payments, meaning just one of the 30 underlying borrowers was deferring payment.
One of the inherent risks in trust preferred deals is that underlying obligors have the right to defer for up to five years (BW, 10/20/2003). Trust preferreds are securities issued by mid-sized banks; cash flows from these securities are then pooled together to pay CDO noteholders.