Clo Interest_aug 09

Moody’s Views on the Global CLO Market August 2009 In this issue

Contact Us EDITORS: Jerry Gluck, Algis Remeza FAX: +1 (212) 298-6875 E-MAIL: [email protected] www.moodys.com

Following a Stressful Period, CLO Performance Shows Some Signs of Stabilization Indicators suggest a near-term bottoming out in the cycle, but refinancing poses a longer term risk. See page 2

CLO Market Pulse Key indices for July were nearly flat in this mostly quiet month. See page 4

CLOs May Fill a Gap in DIP Financing Corporate bankruptcies rise while bank lenders remain cautious.

Contributors Eun Choi Managing Director Katherine Frey Group Managing Director Yvonne Fu Group Managing Director Paul Kerlogue VP-Sr Credit Officer Christina Padgett Sr Vice President Ramon Torres VP-Sr Credit Officer Yuri Yoshizawa Senior Managing Director

See page 7

+1 (212) 553-4962 +44 (20) 7772-5521

No Mystery in the Repackaging of Downgraded CLO Notes Some critics may not fully understand the analysis of this securitization technique. What is it that they are missing? See page 8

+1 (212) 553-7732

Observations on Weighted Average Life Contraction in CLO Portfolios

+44 (20) 7772-8603

Weighted average life in CLO portfolios has declined relatively steadily over the last year. We discuss some empirical data and observations. See page 10

+1 (212) 553-4164 +1 (212) 553-3738 +1 (212) 553-1939

Loan Price Rally Boosts Market Confidence, but CLO Managers Are Cautious Trading decisions must take account of the impact on collateral par values. See page 11

Name Overlap in Cash-Flow CLOs Suggests Limits to Diversification Across CLOs Collateral pools within broad regions hold many common assets. See page 12

Note Cancellation within CLO Transactions and Its Rating Impact Moody’s believes the likelihood of such changes in CLO capital structures is low See page 14

CLO Surveillance Update: The Sweep Continues The sweep continues with further downgrades and a few upgrades. See page 15

Market Value CLO Ratings Revised Following an Update to Methodology New assumptions reflect extreme volatility since Lehman failure. See page 17

Announcements and Publications We list recent events, announcements, and publications. See page 18

Moody’s CLO Interest

The Fundamental View Following a Stressful Period, CLO Performance Shows Some Signs of Stabilization Moody’s observed considerable deterioration in CLO portfolio metrics during the first half of this year. Nonetheless, against the backdrop of a likely ‘hook-shaped’ economic recovery 1 characterized by very slow growth and continued stressful credit conditions, the corporate sector is showing signs of stabilization. Here, we discuss the implications of firming corporate conditions for the future credit performance of CLOs. The Deterioration to Date Has Been Sharp… Corporate default rates continue to edge toward historical highs and have recently surpassed the peak observed during the last recession. During the first seven months of this year, Moody’s trailing global speculative-grade default rate rose from 4.2% to 10.7%. The rate is expected to grow further, topping out at 12.2% globally in Q4 2009. 2 Consistent with this picture, rating transitions for leveraged loans have been sharply negative. For example, over the last year, 15.7% of single-B rated loans have migrated to Caa1 or below, more than double the average one-year transition rate for the preceding five years. Direct measures of CLO collateral performance have mirrored this deterioration. The weighted average rating factors (“WARFs”) of Moody’s-rated CLOs have climbed significantly since late 2008, indicating a substantial decline in the average credit ratings of the loans backing these transactions. Moreover, portfolio par amounts have fallen significantly, as measured by overcollateralization (“OC”) levels. In light of these factors, CLO ratings have undergone significant rating migration during the first seven months of this year. Through July 31st, Moody’s downgraded 2,650 CLO tranches globally, totaling the equivalent of roughly US$118 billion from more than 650 CLO transactions. Of the downgraded tranches, 310 were initially rated Aaa and downgraded by an average of 3.3 notches. …But Some Encouraging Signs have Emerged After leveraged loan prices bottomed near 60 in the months following the Lehman bankruptcy, they have recently risen above 80. Still, current prices are low compared to levels historically near par, indicative of continued caution among lenders. In the last two to three months, we have observed signs of stabilization in some CLO portfolio metrics. Portfolio WARFs, Caa-rated asset and defaulted asset exposures, as well as OC levels have weakened at a slower pace. In some cases, such measures have improved slightly, following significant deterioration starting in late 2008. (In the “CLO Market Pulse” section, we provide more details on CLO portfolio index performance over time.) Despite the expectation of still higher (trailing) speculative-grade default rates by year’s end, Moody’s projects a significant improvement by mid-2010, with the global rate falling substantially to 4.4% by next July. Nonetheless, a significant risk for the leveraged loan market remains in that most loans will not mature until 2013-2014, at which time default rates could rise if credit market conditions remain stressful and refinancing proves difficult. CLO Spreads Remain Wide and Issuance Remains Spotty Any optimism about corporate performance is, at best, filtering slowly to attitudes toward CLO liabilities. CLO liability spreads have fallen. Since reaching their high in the spring, the spreads of Aaa-rated CLO tranches have declined by more than 200 bps. Still, they are substantially higher than the spread levels seen last year prior to the Lehman bankruptcy. In part, the exceptionally wide spreads for Aaa-rated CLO tranches reflect concerns about further downgrades of CLO liabilities. 1 2

See “On the Hook,” Moody’s Global Financial Risk Perspectives, May 2009. See Moody’s “July Default Report,” August 6, 2009.

2

August 2009

Moody’s CLO Interest

Moody’s CLO Interest

With liabilities spreads still wide, new CLO issuance remains very weak. The limited new issuance has been dominated by the repackaging of existing notes or motivated by balance-sheet considerations. We do not anticipate a significant change in this pattern until the signs of market stabilization are unambiguous and a recovery is well under way. ❖ Jian Hu Managing Director +1 (212) 553-7855 [email protected]

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August 2009

Moody’s CLO Interest

Danielle Nazarian Senior Vice President +1 (212) 553-4054 [email protected]

Fei Fern Wang Assistant Vice President – Analyst +1 (212) 553-4621 [email protected]

Moody’s CLO Interest

CLO Market Pulse

Key Indices (month of July)

3

Moody’s key indices for the CLO market continued to show signs of stabilization as rising loan prices helped over-collateralization (“OC”) levels improve somewhat while WARF, Caa buckets, and defaults worsened only slightly in July.

Monthly Change

Level

OC 122.0%

Following last month, OC levels improved marginally. The effect of rising loan prices, including those for Caa-rated and defaulted instruments, outpaced rating migrations into Caa buckets and defaults. Moreover, the impact of defaulting Caa-rated loans was reduced because market-value haircuts for excess Caa buckets already accounted for some of the potential losses. In the coming month, we expect to see a modest decline in the OC index, particularly as a result of defaults of such prominent names as the Reader’s Digest Association.

( +0.1% )

Cash 3.27%

( +0.33% )

WARF 2894

( +8 )

Caa Bucket 9.51%

( +0.12% )

Defaults Cash levels increased modestly in July. Continued improved liquidity in the corporate credit markets has helped foster refinancings, leading to CLO loan collateral prepayments. Market activity has been light, and opportunistic buying by managers has been limited. We expect cash to hover near current levels, possibly increasing a bit in August, with prepayment and buying continuing to offset each other.

6.32%

( +0.11% )

* Based on deals that have provided trustee reports as of August 24 for the month of July and that include such information. "Monthly Change" compares July and June averages for only such deals and, as a result, numbers may differ from the charts below, for which all available deals were used. Approximately, 86% of deals have reported.

CLO Senior OC and Cash Levels Monthly Levels Averaged Across All Moody's Rated CLOs January 2007 - June 2009 OC % 136 134 132 130 128 126 124 122 120 118 116 Jan-07

Cash % 9 8 7 6 5 4 3 2 1 0 Apr-07

Jul-07

Oct-07

Jan-08 OC

3

4

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Cash

Moody’s key indices are based on our global EMS data, using trustee reported figures for 846 Moody’s-rated CLOs. OC is a simple average over all CLO senior over-collateralization levels for tranches initially rated typically Aaa or Aa. Cash is calculated as a simple average over all CLOs of cash holdings as a percentage of notional outstanding. WARF is a simple average of weighted average rating factors over all CLO deals. Caa Bucket and Defaults are simple averages of Caa buckets and defaults as a percentage of notional of collateral outstanding over all CLOs. Note that historical averages could change over time as a result of corrections by deal trustees or Moody’s EMS or late reporting deals. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

CLO Weighted Average Rating Factor and Caa and Defaulted Bucket Sizes Monthly Levels Averaged Across All Moody's Rated CLOs January 2007 - June 2009 WARF 3000

% 12

2900

10

2800 8

2700 2600

6

2500

4

2400 2

2300 2200 Jan-07

0 Apr-07

Jul-07 WARF

Oct-07

Jan-08

Apr-08

Jul-08

Caa Bucket

Oct-08

Jan-09

Apr-09

Defaults

While WARF, Caa-Bucket, and Defaults worsened slightly, they were nearly flat in July. The results were consistent with our expectation of slowing downgrades and defaults of CLO loan collateral ahead of generally improving economic conditions. WARF barely increased as some rating migration occurred, but its effect was partially offset as names defaulted and were removed from the index. Similarly, there were few downgrades to Caa levels and even fewer defaults. Conditional on credit markets’ liquidity continuing to improve, we expect WARF and Caa Bucket levels to continue with a nearly flat downtrend over the next few months because of improving economic conditions and existing Caa-rated assets defaulting, resulting in their removal from the indices. Defaults, however, will continue to increase, especially in August as a result of several significant defaults that have already occurred, at least until the expected economic recovery takes effect. CLO liability spreads have continued to narrow in July and August, although they are still much higher than historical levels or even pre-Lehman bankruptcy levels. The Aaa CLO spread is around 425 bps in August, compared to 650 bps in April, but it is still higher than the 230 bps immediately preceding the Lehman Bankruptcy in September 2008. 4 This suggests that despite improvement in some of the CLO metrics, concerns about CLO performance continue to overshadow the improved sentiment toward underlying corporate credits. The narrowing of CLO liability spreads is highly correlated to the improving leverage loan market. Although the range is wide, average loan prices have continued to move higher in August. Average bid prices for loans in the Ba category have moved closer to mid-90 levels, compared to the 70s at the beginning of this year. Prices for Caa loans have moved above 70, almost double their lows of late March. Loan price improvement has continued to contribute to the better OC ratios in recent months. Loan prices have become a more important within the calculation of the OC ratio as Caa and defaulted buckets have continued to rise. ❖

4

“Source: Citi Investment Research and Analysis

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August 2009

Moody’s CLO Interest

Moody’s CLO Interest

US CLO Spread Performance by Rating January 2007 - August 2009 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Dec-08 Mar-09 Jun-09 Jul-09 Aug-09 Aaa

Aa

A

Baa

Ba

Source: Citi Investment Research and Analysis

Philip Grossman Associate Analyst +1 (212) 553-3681 [email protected]

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August 2009

Moody’s CLO Interest

Algis Remeza Vice President – Senior Credit Office +1 (212) 553-4362 [email protected]

Fei Fern Wang Assistant Vice President – Analyst +1 (212) 553-4621 [email protected]

Moody’s CLO Interest

CLOs May Fill a Gap in DIP Financing DIP Loans Carry Special Protections Debtor-in-Possession (“DIP”) loans are a special form of court-approved financing made to distressed companies under Chapter 11 of the U.S. Bankruptcy Code (the “Bankruptcy Code”). Historically, DIP loans have been attractive to lenders — including many CLOs — because of potentially favorable risk/reward characteristics. In addition to the protections offered by the Bankruptcy Code, DIP loans also typically carry high yields, commitment and exit fees. The high returns for the degree of credit owe to the complexity of DIP financing and the fact that they are loans to bankrupt entities. DIP loans also typically have short maturities (under 2 years). The rationale behind DIP loans is to give distressed companies access to financing while a reorganization is worked out. In order to incentivize lenders, the Bankruptcy Code extends certain protections to providers of DIP financing. Unsecured DIP financing benefits from a superpriority claim which is senior to all other prepetition unsecured claims of the company. If unsecured borrowing cannot be obtained, a distressed debtor is also able to seek new secured financing subject to court approval. 5 Moody’s has developed a database of DIP facilities issued by 297 large publicly registered companies which covers the period between 1998 and 2008. Of the 297 cases in the sample, only 2 DIP facilities have experienced payment defaults (Marvel Entertainment Group and Winstar Communications). 6 When analyzed on a monthly cohort basis, this implies a default probability of about 0.5% which is consistent with a low investment grade rating. This empirical finding is consistent with the strong protections offered to DIP lenders.

CLOs May Step in For Some Traditional DIP Lenders With increasing numbers of companies becoming distressed, the demand for DIP financing is expected to be strong. However, recent dislocations in the credit markets have also greatly reduced the availability of DIP financing to distressed companies. Traditionally, DIP lenders have been large commercial banks and specialist financing institutions. The current financial crisis may have impaired the ability and appetite of some of these participants to extend new credit to distressed companies. 7 Given the constraints faced by traditional DIP market participants and the current attractive pricing of DIP loans, non-traditional sources of funding such as CLOs and hedge funds may emerge to meet some of the excess demand for DIP financing. 8 For example, recent DIP loans issued by Quebecor and LyondellBasell have attracted increased interest from CLOs for both the DIP and exit financing packages. 9 Some CLOs are permitted to invest in DIP loans while others are prevented by their indentures from doing so. Generally, Moody’s believes that the inclusion of a limited amount of DIP loans does not pose significant incremental credit risk to a CLO. For DIP loans satisfying certain criteria, Moody’s considers such loans eligible CLO collateral rather than defaulted assets. Moody’s assumes a 50% base recovery rate and a Moody’s Default Probability Rating of one notch below Moody’s Rating of the facility for these instruments. 10 Typically market practice is to limit the aggregate DIP loan concentration in a CDO to, say, 10% of the aggregate collateral. A further limit of 2% of the aggregate collateral balance for any single obligor is also common. ❖ William Ma Vice President – Senior Analyst +44 (20) 7772-5643 [email protected] 5

6 7

8 9

10

7

In order to do so the DIP must, among other things, demonstrate to the court that no alternative sources of funding are available and that the proposed financing is in the best interests of the creditors See “Moody’s Comments on Debtor-In-Possession Lending” October 2008 Another factor that may be contributing to the scarcity of DIP financing is the scarcity of available exit financing options. Typically, DIP facilities have been repaid with post Chapter 11 financing facilities that the company is able to secure during the reorganization process. In relation to CLOs participation may come mostly from US CLOs as few European CLOs currently have the ability to invest in DIP loans. For a more in depth discussion of Moody’s rating criteria for the inclusion of DIP loans in CDOs see “Responses to Frequently Asked CDO Questions (Third of Series)” March 29, 2004 and “Moody’s Approach to Rating Collateralized Loan Obligations” August 12, 2009. See Question 4 of “Responses to Frequently Asked CDO Questions (Third of Series),” Moody’s Special Report, March 29, 2004. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

No Mystery in the Repackaging of Downgraded CLO Notes In recent months, some investment banks have begun (or resumed) “repackaging” downgraded senior CLO tranches. Critics of this practice have argued that it appears to be the creation of something from nothing—in effect, ‘alchemy.’ 11 We maintain here that such repackagings can in fact produce at least one class of notes more creditworthy than the underlying CLO tranche, and that they are relatively straightforward. In a nutshell, repackaging creates a new security by combining existing securities with additional buffers— either by redirecting cash-flows or by stripping out risks—on top of the credit enhancement incorporated in the original CDO structure. Naturally, this results in improved credit quality for the instrument that enjoys additional credit support. More specifically, the repackaging typically works as follows. An existing CLO tranche, which is traded on the secondary market, is transferred into a newly created special purpose vehicle (“SPV”). To finance the purchase of the tranche, the SPV issues notes with a senior/subordinated payment priority structure (Figure 1). The SPV then receives all income, typically interest and amortizing principal, generated by the CLO tranche, which is the only asset held in the SPV. All the cash flows received by the SPV are distributed according to a pre-determined priority of payments. Principal and interest payments are made sequentially, first to the most senior repackaged note, then to the next most senior note, and so on. In a recent repackaging transaction, the Class A (senior-most) notes issued by a CLO structured in 2007 were re-tranched into three newly created certificates. The original notes had been downgraded from their initial rating of Aaa to Aa3. The senior repack notes that were issued by the SPV comprised about 80% of the total issuance, the mezzanine certificate around 19.5%, and junior repack notes the residual. 12 For the repackaged notes, interest was to be paid sequentially, first to senior and mezzanine notes in a total amount equal to the coupon due on the CLO tranche. The principal proceeds were to be used first pay the senior repackaged notes until paid in full, then to class mezzanine class. Any excess cash flows were to be distributed to junior certificates. Moody’s assigned a Aaa rating to the senior repack notes, while the mezzanine and junior notes were not rated.

Figure 1: Repackaging Diagram CDO Liability Tranches

‘Repack’ Notes

 

 

Senior Repack

Class A

  SPV

Class B

SPV

Mezzanine Repack

Class C Class D

Junior Repack

Class E

11 12

8

See, for example, http://www.creditwritedowns.com/2009/07/financial-alchemy-at-morgan-stanley-greywolf-a3-cdos-now-aaa-bonds.html. Thus the total par of the repackaged notes matches that of the CLO tranche that was repackaged. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

There should be nothing surprising about the idea of a Aaa rating of the senior repack notes vis-à-vis the (post-downgrade) Aa3 rating of the senior CLO liabilities. The repack notes, whose par amount is roughly 20% smaller than that of the CLO liability, benefit from additional credit enhancement. Because of their seniority relative to the mezzanine and junior repack notes, they are better supported by the cash flows generated by the CLO collateral pool than are the original CLO senior liabilities; i.e., they are more creditworthy. It is important to understand that this does not mean that the creditworthiness of the repack notes in the aggregate is any better than that of the senior CLO class. Since the repack notes collectively receive the same cash flows as the CLO Class A, they have exactly the same aggregate credit quality. Only the senior repack notes (which, for example, may represent 80% of the Aa3-rated CLO Class A issuance) are of better credit quality and, in this case, merit a Aaa. On the other hand, the subordinated repack notes (which may represent the bottom 20% of CLO Class A issuance) are of typically poorer credit quality than the underlying CLO Class A notes because these notes now first absorb all losses (up to 20% of CLO Class A issuance). In such an example, the subordinated repack notes would likely warrant a rating worse than Aa3. 13 If CDO repackaging has, in the aggregate, no impact on credit quality, why do we observe the practice? In some cases, repackaging can be used to take advantage of pricing arbitrage opportunities. For example, the pricing of Aaa-rated tranches may be so favorable relative to pricing for more junior tranches that it is worth splitting non-Aaa tranches in the manner described above. In other circumstances, repackaging may be motivated by an effort to achieve better accounting or regulatory capital treatment. Finally, if some portion(s) of the repack notes are sold to a third party, there may be an opportunity to lower the overall risk profile of the original CLO note holder. Though repackaging has been applied for years in the CLO market, there is naturally heightened interest today because of the numerous downgrades of once-highly-rated CLO tranches Regardless of the motivation, the repackaging of CDO tranches, which we have observed for at least a decade, will almost certainly continue, so long as it is understood and approved by the relevant regulators. It relies on perhaps the most fundamental of structured finance concepts—subordination—to enhance the creditworthiness of a fixed-income security. 14 ❖ Leon Mogunov Vice President – Senior Credit Officer +1 (212) 553-3803 [email protected]

13 14

9

Moreover, if the holder of the senior CLO tranche retains all the repack notes, neither its risk profile nor its economic capital requirements should change. For a detailed discussion of Moody’s methodology for rating repacks, see “Rating CDO Repacks: An Application Of The Structured Note Methodology.” Note that credit enhancement could also be achieved by other means. For example, one could repackage a CDO tranche with a U.S. Treasury obligation that effectively ensures the repayment of a portion of principal and/or interest. Or, credit protection could be purchased in combination with the repackaged note that protects against certain losses in the underlying CLO collateral pool. Nonetheless, the simple subordination scheme illustrated above is the most common approach. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Observations on Weighted Average Life Contraction in CLO Portfolios The default probability of an asset is a function of both its credit quality and the period of exposure to that asset. For a CLO portfolio that typically carries homogeneous characteristics, Moody’s analysis of the collateral’s weighted average default probability is determined by two factors: the Weighted Average Rating Factor (“WARF”) and Weighted Average Life (“WAL”) of the pool. Holding WARF constant, a CLO portfolio with a higher WAL will also have a higher default probability, and vice versa. WAL in actively managed CLO portfolios has declined relatively steadily over the last year. We discuss some empirical data and observations here. As of June 2009, CLOs rated by Moody’s between 2004 and 2008 had on average a portfolio WAL of approximately 4.3 years in the U.S. and around 5.5 years in Europe. 15 Between July 2008 and June 2009, the portfolio WAL for CLOs rated globally between 2004 and 2008 decreased on average by roughly 0.75 years. 16 While the WAL declines have not exactly matched the elapsed time, these data provide clear evidence for WAL contraction. We believe this trend can be attributed to the following two factors: The global leveraged loan new issuance market remains largely inactive after hitting a peak in 2007 and then declining drastically in 2008. There is a general expectation that the muted volume will continue in the near future. As a result, CLO reinvestment opportunities are largely limited to secondary issues, which are less likely to extend the portfolio WAL. Recent downgrades of CLO liabilities limit the manager’s scope for discretionary asset sales in CLOs and, as a result, the turnover of CLO portfolios is also constrained. In most CLO documentation, discretionary sales are shut off when certain rated CLO notes are downgraded by a certain number of notches, unless noteholders elect to turn them back on. Credit risk and credit improved sales are still allowed, but under certain more restrictive conditions as described by the CLO documentation. Managers are thus somewhat constrained in selling assets and making reinvestments using the proceeds of such sales. However, other factors have worked against the shortening of CLO WAL. Specifically, Some companies have negotiated amendments to extend the maturities of a portion of their loans in exchange for higher interest rates and/or fees. Notably though, amend-to-extend deals still represent a tiny fraction of the entire leveraged loan universe. Furthermore, amend-to-extend has largely been a viable option only for select higher quality issuers with adequate near-term liquidity, while most stressed issuers are unable to negotiate acceptable terms with their lenders. The volume of global high-yield bond issuance has picked up in 2009 and is expected to further increase for the full year 2009 from 2008 levels. Proceeds from such offerings have been used primarily to refinance existing bonds and leveraged loans. When loans in CLOs are prepaid due to refinancing from bond issuance, most CLO managers have been opportunistically using such prepayments to purchase loans in the secondary market, which is again less likely to extend CLOs’ portfolio WAL. However, to the extent that a CLO purchases new issuances of high yield bonds, portfolio WAL can potentially be extended. Nevertheless, such purchases will be constrained by both the deal’s maximum fixed-rate asset basket and its maximum bond basket, which is no more than 5% of par in a typical CLO.  Given the observed reduction in average life, these WAL-extending forces have clearly been less meaningful for CLOs overall. However, as we analyze each transaction, we consider the factors affecting WAL for each portfolio. ❖ Oktay Veliev Analyst +1 (212) 553-7467 [email protected] 15 16

10

Min Xu Assistant Vice President – Analyst +1 (212) 553-7228 [email protected]

Moody’s looked at a sampling of 474 CLOs from that period for this analysis: 396 rated in the U.S. and 78 in Europe. This analysis is based on a subgrouping of 428 CLOs for which we had WAL information from both July 2008 and June 2009. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Loan Price Rally Boosts Market Confidence, but CLO Managers Are Cautious U.S. and European leveraged loan prices have reached their highest levels in over a year. Although a lot has been written about the positive effects on CLO Overcollateralization (“OC”) Ratios, rising loan prices have not necessarily translated into a spike in trading activity for most CLOs. Managers continue to use caution to buy opportunistically. While total return and other unlevered funds actively purchased loans at deeply discounted prices over the past year, most CLO managers stayed away from these loans priced well below 80%-85% due to disincentives in the calculation of their OC ratios. Now that average loan prices have hit levels as high as the 90s for Ba- and some B-rated loans, one would have thought that CLO managers would flock to the secondary market to acquire better-quality loans that could improve their portfolios without penalizing calculated OC levels, but this has not yet been the case.

Cash Needed to Fund a Buying Spree Looking across the universe of CLOs, we’ve found that the average level of cash held by CLOs for reinvestment has hovered around 3% of total principal over recent months. While there has been some prepayment activity among better quality borrowers, it hasn’t been significant enough to induce any material buying spree. Therefore, in order for CLO managers to purchase large quantities of loans, they must sell others in their portfolios. The majority of CLOs purchased their loans during a par market a few years back. Even with the higher loan values, many managers are loath to crystallize a principal loss unless they believe these loans may default.

Caas: To Sell or Not to Sell Most CLOs have OC penalties for excess Caa concentrations, whereby some portion of the Caa-rated loans must be held at their current market values rather than par. These Caa haircuts have been reduced as the average price for Caas has rebounded from the mid-30s to as high as 60+. At this time, managers have a difficult decision to make of whether or not to sell their Caa assets. With OC pressure somewhat alleviated, they may prefer to hold their better quality Caa assets in hopes of further price increases or par repayment at maturity. For those Caa assets that are perceived to be of lesser quality, they may decide to sell if they believe the market is pricing the loans appropriately. Once they sell, however, the main question is what to buy with the proceeds.

Looking for the “Sweet Spot” Another OC penalty that most CLO managers have to contend with is the “deep discount” haircut. Most transactions are expected to hold a loan purchased below 80% or 85% at its purchase price, depending on the terms of the CLO. As such, there is a “sweet spot” just above the price cutoff, where the CLO can purchase the loan at a discount, but still hold it at par for the OC test. There is some sentiment in the market that given current high-yield default predictions, loan prices have risen too high and are expected to experience a correction in the coming months as corporate defaults and downgrades continue to occur. Our own July monthly default report projects that defaults will continue increasing with peaks at 12.7% in the U.S. in Q4 2009 and at 12.0% in Europe in Q1 2010, which supports this sentiment. 17 Some CLO managers seem to be limiting their trading activity in anticipation of this correction in hopes that more loans will fall closer to the sweet spot. Meanwhile, they continue to cautiously identify individual opportunities for improving their portfolios at attractive prices. ❖ Ian Perrin Vice President – Senior Credit Officer +44 (20) 7772-5534 [email protected] 17

11

See Moody’s “July Default Report,” August 6, 2009 August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Name Overlap in Cash-Flow CLOs Suggests Limits to Diversification The recent period of extraordinary volatility in the performance of financial assets highlights the potential benefits of diversification—where possible—across investment portfolios. In the context of the CLO market, one might ask whether such diversification is indeed possible. The widespread downgrades of CLO tranches over the past six months imply significant limits on the extent to which diversification can prevent correlation in credit performance across a range of CLO liabilities. Whether ultimate cash returns to buy-and-hold CLO investors are highly correlated across transactions remains to be seen. One key determinant of the ability to diversify cash-flow performance is the extent to which a common set of assets are included in different CLOs. A forthcoming Moody’s study reveals that a degree of diversification is possible, primarily by spreading investments across CLOs issued in the U.S. vs. European markets, and across CLOs run by different collateral managers.

Typical Portfolio Overlap Levels Are High To answer the question of how much overlap there is in CLO collateral pools, we examined hundreds of U.S. 18

According to the particular measure we have used, collateral and European transactions rated by Moody’s. overlap ranges from 0% to 100%, with an average value of 24%. To provide some context for these figures, CLO senior tranche subordination levels average around 30%. This suggests that the average overlap levels are high enough to be a concern for all the tranches in the capital structure—certainly enough to produce common ratings performance (as we have seen), but also enough to affect cash-flow performance through defaults in the collateral pools. The average overlap figure obscures some important distinctions, however. Table 1 shows the extent of this overlap for U.S. and European high-yield, cash-flow CLOs. .

Table 1 Average Overlap for U.S. and European CLOs US CLOs European CLOs

US CLOs 35% 8%

European CLOs 8% 38%

The table shows that while overlap is very significant for pairs of U.S. and pairs of European CLOs, it is quite low (8%) across pairs comprised of one CLO from each region. The managers in both areas evidently tend to specialize in regional portfolios. Such market segmentation is partly the product of trading provisions that restrict investing across currencies; US CLOs primarily invest in the US dollar loan market whereas European CLOs tend toward Euro-denominated assets. Indeed, the CLO manager itself is a key influence on the extent of portfolio overlap. As Table 2 shows, overlap between CLOs managed by a single entity is extremely high--around 70% regardless of region. The findings presumably reflect manager’s selection processes in which they identify attractive investments and spread purchases across the various deals that they manage.

18

We evaluated the overlap according a commonly used formula where the overlap is defined as the sum of the average exposure (in percentage) of each asset in common between the two portfolios. (See, for example, ‘CLO Portfolio Overlap “Déjà Vu”’ published by UBS Investment Research (Douglas Lucas and Danny Newmann) on September 29, 2008.) Our study incorporates data from 458 US and 174 European CLOs rated by Moody’s between 2004 and 2008. The average overlap is a simple average of the overlap between all the possible pairs of deals. By design, the pair-wise overlap results vary within a range from 0% to 100%. The standard deviation is 12% for US CLOs and 14% for European CLOs.

12

August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Table 2 Average Overlap for CLOs with Same or Different Managers Same manager Different managers

US CLOs 73% 34%

European CLOs 67% 37%

Another possible strategy for diversification is investment in CLOs of various vintages. Our analysis indicates that overlap by vintage is similar from year to year. That is, overlap between a pair of, say 2004 CLOs is similar to that for a pair of 2008 CLOs. A more interesting finding is that diversification across different vintages has little benefit. The average overlap between two CLOs of different vintage is similar to the average for CLOs within a specific vintage. The implication is that throughout the life of any CLO, managers constantly trade assets in the same market whatever the vintage of the deal. 19

Conclusion We have seen that diversification across CLO collateral pools can best be achieved by investing in both U.S. and European CLOs and by avoiding transactions managed by the same entity. Of course, investors who firmly believe that one region or one manager will outperform others may choose to concentrate their holdings. For better or for worse, the cash returns among their various holdings will likely exhibit a high degree of correlation. Moody’s upcoming report on CLO collateral overlap will shed further light on these findings. ❖ Julien Sieler Vice President – Senior Analyst +1 (212) 553-4716 [email protected]

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While portfolio credit quality is a major factor in the performance of a CLO, the structure and the cash flow diversion features (e.g., OC tests) of a CLO can provide material sources of differentiation among transactions, especially across different vintages. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Note Cancellation within CLO Transactions and Its Rating Impact 20 On July 28, 2009, KKR Financial Holdings LLC surrendered for cancellation multiple mezzanine and junior notes from three CLO transactions (KKR Financial CLO 2005-1, KKR Financial CLO 2005-2 and KKR Financial CLO 2006-1) without receiving payment in return. Prior to the note cancellations, KKR Financial Holdings LLC had owned, directly or indirectly, all of the mezzanine notes and subordinated notes issued by the 2005 CLOs, and 80% of these notes issued from the 2006 transaction. Removing these notes from the capital structure of each of the three CLOs has caused mezzanine and junior OC ratios in each of the deals to improve such that previously failing tests were brought into compliance. Thus, instead of interest proceeds being diverted to pay down senior notes on each transaction’s payment dates until the OC tests are cured, interest proceeds will flow through each waterfall to pay interest to the mezzanine and subordinated notes. The note cancellations reduced expected losses on notes junior to the cancelled notes, as well as on the remaining portion of those notes that experienced partial cancellations. As a result, Moody’s raised the ratings on six tranches in the three transactions by one to seven notches. Conversely, the expected losses on notes senior to those that were cancelled increased due to the notes delevering less quickly. Upon review, Moody’s downgraded two senior classes in one of the transactions by one notch, but the negative impacts on the senior tranches of the other two transactions were not large enough to affect the ratings. Typically, note cancellation provisions do not require that notice be sent to rating agencies. Since neither rating agency confirmation nor notification was required, Moody’s was not in a position to offer an opinion prior to the note cancellations. Moody's had previously assigned a low likelihood to the occurrence of the cancellation of the notes without receiving payment in return. In situations where there are multiple holders of the mezzanine and subordinated notes, and no definitive alignment of interests between them, it remains Moody’s opinion that the likelihood of this type of action taking place in other CLOs is low. We will be reassessing the impact of these types of actions and will determine how to reflect it in our CLO rating methodology going forward. ❖ Evan Tepper AVP-Analyst +1 (212) 553-7137 [email protected]

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For a more detailed discussion of this topic, see “Note Cancellation within CLO Transactions and its Rating Impact” (August 2009) August 2009

Moody’s CLO Interest

Moody’s CLO Interest

CLO Surveillance Update The Sweep Continues In the July issue, we summarized the rating actions taken on CLOs in the second quarter of 2009. From July 1 to August 19, 2009, we downgraded another 865 CLO tranches in 199 transactions, totaling approximately US$63 billion. We also upgraded 30 tranches in 18 transactions, totaling approximately US$800 million. Of the 865 downgraded tranches, 714 were from 170 U.S. CLOs totaling US$53 billion and 151 were from 29 European CLO transactions. Downgrades affected 249 tranches that were previously rated Aaa, about 29% of all such tranches. Combined with rating actions taken in the first half of 2009, Moody's has downgraded 2,852 CLO tranches (roughly 60% of the 4,762 tranches outstanding), totaling US$137 billion globally. During the second quarter, our sweep tended to focus on deals that have exhibited weaker-than-average performance. Some of the deals that we have reviewed more recently have been average to better-thanaverage performers, and upgrades on certain deals have occurred. Of the 30 upgraded tranches, 28 were from 16 U.S. CLO transactions. Most of these upgrades resulted from a comprehensive deal-level analysis incorporating Moody's revised assumptions 21 , where the analysis indicated that the impact of the current stresses on the ratings of the notes was not as negative as previously assessed during Stage I of the review in March. Stage II reviews include an in-depth assessment of results from Moody's quantitative CLO rating model, along with an examination of deal-specific qualitative factors. By way of comparison, Moody's took rating actions during Stage 1 that were largely the result of a parameter-based approach (see press release dated March 4, 2009, titled "Moody's puts all but senior-most CLO tranches on review for downgrade"). For the 30 tranches that we upgraded, most of the actions were from one to two notches in magnitude, with a few upgrades by three to four notches. There were three tranches within three CLO transactions for which the upgrade magnitudes were more prominent due to note cancellations 22 .

CLO Sweep Rating Changes (March 3 - August 19, 2009 by tranche) 3-Mar Aaa Aa A Baa Ba B Caa Ca/C

Aaa

Aa 955 1 1 957

A 289 503 2 794

Baa 116 157 105 378

Current Rating Count Ba B Caa Ca/C WR Total 6 6 12 1384 130 31 4 3 829 330 350 34 14 3 3 842 215 258 346 138 54 13 1024 77 199 197 147 4 624 19 8 3 3 33 10 6 2 18 1 1 2 32 4 40 681 723 603 369 245 44 4794

Moody’s posts an updated CLO Transition Matrix within “Weekly Rating Action List for Global CDOs and Derivatives” every Monday. Please visit moodys.com for weekly updates. ❖ Karie Chen Assistant Vice President – Analyst +1 (212) 553-1053 [email protected]

21 22

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Qi Wang Assistant Vice President – Analyst +1 (212) 553-7461 [email protected]

These revised assumptions are described in the publication “Moody's Approach to Rating Collateralized Loan Obligations,” dated August 12, 2009. Please refer to Moody’s Special Comment on “Note Cancellation within CLO Transactions and its Rating Impact” published on August 21, 2009 and summarized in the preceding CLO Interest article. August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Market Value CLO Ratings Revised Following an Update to Methodology In April 2008, we proposed revised volatility and liquidity parameters in a request for comment, "Moody's Proposes Revisions to Its Parameters for Corporate Assets Held in Market-Value CDO Transactions." The proposed changes in the parameters we use to calculate advance rates for market-value CLOs (“MV CLOs”) reflected the unprecedented volatility and illiquidity in financial markets since 2007. After incorporating market participants' comments, we published our revised modeling assumptions and monitoring approach in July 2009 in the report "Moody's Modifies Its Modeling Assumptions for Market-Value Collateralized Loan Obligations.” In MV CLOs, the protections to the rated notes are provided by advance rates and over-collateralization (“OC”) requirements. The underlying assets are frequently marked to market and the resulting values are discounted by the advance rates. These discounted values are compared to the outstanding liabilities of the MV CLO to assess compliance with OC requirements. To the extent that a transaction fails to meet its OC requirements, the breach needs to be cured within a predetermined period (typically 10 business days). A failure to comply within the specified cure period triggers an event of default, which may lead to a liquidation of the portfolio. As a result of implementing our updated advance rates, we have recently downgraded 92 tranches across 17 MV CLOs (affecting around $13 billion in face value) and confirmed the debt of two MV CLOs (about $470 million in face value). The rating downgrades averaged about four notches for tranches previously rated Aaa, and roughly eight notches for tranches previously rated Aa1 through A3. While the actions on the most senior tranches were influenced mostly by the updated advance rates and required OC levels, the rating actions on subordinated tranches were in part due to our consideration that the tranches without control rights during a liquidation scenario may not fully benefit from the market-value cushion implied by the advance rates. Specifically, the controlling parties may seek to maximize their returns without regard for the interests of subordinated classes through, for example, "cherry picking" in the liquidation process. For this reason, the risks to holders of subordinate MV CLO tranches may not be consistent with an investment-grade rating. While the downgrades ultimately resulted from the extraordinary volatility and illiquidity that has characterized the market for corporate assets since mid-2007, it is notable that most transactions have been operating at OC levels well above the required levels. For example, the average senior OC level of MV CLOs in June 2009 was 169%; i.e., there was 69% more market-value protection than required under the advance rates built into the transaction documents. 23 In part, this cushion existed because most of the transactions have not utilized available leverage in the sense that they have not fully drawn on revolving liabilities. Even if they had fully used revolving facilities, these CLOs would still have had a cushion of around 33% in their OC test levels in June. As another means of mitigating the impact of market price fluctuations on OC test compliance, MV CLOs have maintained a substantial share of their assets—35% in June—in cash and cash equivalents. Moody’s final rating decisions have taken into consideration these defensive strategies that transactions have implemented during this difficult credit cycle. However, we have taken only partial account of excess marketvalue cushions, available cash positions, and conservative leverage strategies because they are not contractually required and the benefits from conservative management may disappear as the transactions begin to implement more aggressive strategies. For that reason, our rating decisions relied mostly on adequacy of the advance rates incorporated into transaction documents relative to the updated advance rates. While the defensive strategies are being implemented across transactions for the time being, MV CLO managers may take a more aggressive approach once the market stabilizes and more trading opportunities arise. ❖ David Ham Vice President – Senior Credit Officer +1 (212) 553-7192 [email protected] 23

It should be noted that the advance rates used to determine this OC cushion are the ones built into the transaction documents of the MV CLOs. Using the updated advance rates that take into account the more recent price volatility and illiquidity in the market, the cushions for all deals would be significantly lower or non-existent in some cases.

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August 2009

Moody’s CLO Interest

Moody’s CLO Interest

Announcements “Structured Finance Ratings Quick Check” (August 31, 2009) “Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (August 31, 2009) “Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (August 24, 2009) “Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (August 17, 2009) “Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (August 10, 2009) “Weekly Rating Action List for Global CDOs and Derivatives - Excel data” (August 3, 2009)

Publications “Default & Loss Rates of Structured Finance Securities: 1993-2008” (August 21, 2009) “Default & Loss Rates of Structured Finance Securities: 1993-2008 - Excel data” (August 21, 2009) “Note Cancellation within CLO Transactions and its Rating Impact” (August 21, 2009) “Collateralized Debt Obligations Performance Overview Compilation Europe, July 2009” (August 10, 2009) “Monthly Default Report – July 2009” (August 6, 3009) “Outlooks for Global CDOs and Derivatives: Mid-Year 2009 Update” (August 5, 2009) “May 2009 Cash CDO Asset Exposure Data (1 of 2)” (August 3, 2009) “May 2009 Cash CDO Asset Exposure Data (2 of 2)” (August 3, 2009) “Collateralized Debt Obligations Asset Exposure May 2009” (August 3, 2009) “Moody's Deal Score Report CDO Deal Summary Performance May 2009” (August 3, 2009) “Collateralized Debt Obligations Tranche Acquisition May 2009” (August 3, 2009) “CDO Performance Overview Compilation - U.S. Cash” (August 3, 2009) “Moody's Equity Score Report CDO Deal Summary Performance May 2009” (August 3, 2009) “Moody's CLO Interest (Newsletter) - July 2009” (August 3, 2009) To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

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August 2009

Moody’s CLO Interest

Moody’s CLO Interest

About Our Organization… Moody's Derivatives Group is the leading source for credit ratings and research on collateralized loan obligations (CLOs), collateralized bond obligations (CBOs) and the entire structured derivatives market. The CDO group leverages Moody's decades of experience in Bank Loans and High Yield as well as our marketleading Default Studies to produce the most accurate rating methodologies for this asset class.

Report Number: SF177355 Editors Jeremy Gluck, Algis Remeza

CREDIT RATINGS ARE MOODY'S INVESTORS SERVICE, INC.'S (MIS) CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MIS DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL FACT. CREDIT RATINGS DO NOT CONSTITUTE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS ARE NOT RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES. CREDIT RATINGS DO NOT COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MIS ISSUES ITS CREDIT RATINGS WITH THE EXPECTATION AND UNDERSTANDING THAT EACH INVESTOR WILL MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE. © Copyright 2009, Moody’s Investors Service, Inc., and/or its licensors and affiliates (together, "MOODY'S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided “as is” without warranty of any kind and MOODY’S, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000. Moody’s Corporation (MCO) and its wholly-owned credit rating agency subsidiary, Moody’s Investors Service (MIS), also maintain policies and procedures to address the independence of MIS’s ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moody’s website at www.moodys.com under the heading “Shareholder Relations — Corporate Governance — Director and Shareholder Affiliation Policy.”

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August 2009

Moody’s CLO Interest