With downgrades mounting in the CDO markets last year, investors were seeing an increase in features designed to provide early intervention in the case of portfolio deterioration and address the problem of abusive manager strategies. Danielle Nazarian, v.p. and senior credit officer at Moody's Investors Service, highlighted 11 structural protections that were either in their infancy or were becoming the standard on deals in a report that was widely acknowledged by managers and underwriters. Nazarian discusses with LMW progress made since the report was issued last summer and what more to expect in terms of structural enhancements.
LMW: Of the protections that last year were rarely applied or were not very common, which ones now have wider acceptance to address collateral deterioration?
The most standard are the supplemental re-investment overcollateralization (O/C) tests and excess Caa haircuts, which are now much more common than before. Investors understand that as Caa buckets grow, the deals become riskier. Therefore, such tests are appealing because the rationale behind them is clear and their mechanics are easy to understand.
The fact is, prior to this, O/C tests were pretty binary. The O/C triggers in some CDOs were set at levels so low that a violation would only occur after significant deal deterioration. The supplemental O/C tests are a way of testing the deal on its way down and they kick in before amortizing tests are violated. It makes logical sense to have this feature in a deal. The supplemental tests usually incorporate Caa haircuts.
One feature that was common before this report was written, but not universally applied uniformly, involves using the lower of market value or pre-determined recovery value for defaulted securities in the O/C tests. This feature is something we have pushed to consistently incorporate into all deals.
LMW: What features designed to address abusive practices have caught on?
We're definitely seeing more attention paid to the treatment of discounted securities. When a security is bought at a discount, it can be treated at full par in the O/C tests if it subsequently maintains a higher price for some pre-determined time period. For example, say a bond is purchased at 70-75; once it trades up to, say 85, and maintains that price for 30 consecutive days, it is able to be treated at full par in the O/C tests.
There are different ways of handling discounted purchases. For example, you could have a prohibition against buying securities below a cut-off price, but such a feature has pros and cons. Buying discounted securities, in itself, is not necessarily a bad thing. As long as the risk is reflected in the transaction, then it might be appropriate, to a limited degree.
There are also limits on Caa purchases that you see from time to time, whereby the manager is prohibited from buying securities rated below B3. We would not require such an outright prohibition per se, but are not unhappy to see it there. This eliminates the churning of the Caa bucket.
LMW: Do you have any other new ideas or enhancements that Moody's would like to see?
The majority of the enhancements I have seen lately are variations on the 11 laid out in this report. There are so many different ways of handling or incorporating the effects of these tests. With respect to discounted purchases, where do you draw the cutoff for what is discounted? How do you handle bonds and loans? Moody's rated one deal in which the test for discounted purchases was meant to handle weak loans. If the loan was purchased at less than 50, it was treated as a defaulted security in the supplemental reinvestment O/C test.
The inclusion of these features is tailored to the managers' goals. You want to provide managers with the flexibility to carry out their investment philosophies and not tie their hands too much while, at the same time, maintaining the integrity of the ratings analyses.
LMW: Which enhancements have not been accepted and why?
Of the 11 enhancements discussed in the July report, two have not been widely adopted for very particular reasons. The tailoring of the interest coverage test in order to eliminate the need for a weighted-average coupon test was designed for a specific structure that has not been widely seen in the market so there hasn't been a specific need for it. Also, dynamic triggers have not been widely applied because they are complex to implement and analyze.
LMW: Which of the enhancements has really become more standardized for CLOs in particular?
Most of the features we've discussed are applicable or adaptable for a variety of deal types, including CLOs.
LMW: Have these enhancements worked to protect collateral quality and prevent manager abuse?
I think these features are focusing attention on the right issues and moving these structures into better alignment with our ratings analysis. If these features are implemented properly, they will certainly have positive effects for the notes. However, all the structural features in the world could not have offset the deterioration in some CDOs that resulted from the very difficult credit environment we've undergone over the last few years. Once deals with various features become more seasoned, it would be an interesting exercise to isolate the effects of these features on notes' ratings.
Q & A
Features Designed to Address Collateral Deterioration
* Supplemental Reinvestment O/C Tests
* Discretionary Reclassification of Interest Proceeds as Principal Proceeds
* Treatment of Securities as Defaulted
* Excess Caa Haircut
* Using Lower of Market Value or Predetermined Recovery Value for Defaulted Securities
* Treating Securities on Watchlist as Downgraded/Upgraded
* Giving Teeth to the Interest Coverage Tests
* Dynamic Triggers
Features Designed to Address Abusive Manager Practices
* Limiting/Monitoring Deeply Discounted Purchases
* Limiting Caa Purchases
* Improved Treatment of Realized Gains