Wednesday, June 3, 2009

CLO managers forced into bad behavior

S&P recently came out with an interesting repot on CLO (collateralized loan obligation) manager behavior in this environment. It’s definitely worth reading – it’s fairly concise and explains concepts well even for those who are unfamiliar with CLOs.

In a "cash-flow" CLO most collateral is held at par (not mark to market), with a few exceptions. With rapid-fire corporate loan downgrades by the rating agencies, CLOs’ so called “CCC baskets” (a 5-10% limitation on CCC+ and lower rated loans) get overfilled. That CCC basket overage gets a harsh (lower of mark to market or recovery) treatment for the purposes of determining the “value” of the collateral (all this is baked into the indenture documents). At some point the reduced collateral value causes CLOs to bust their over-collateralization (O/C) tests, forcing the CLO to redirect cash flow from equity and subordinated fees to pay down principal on senior tranches. Note that the media often confuses the OC test breach with an event of default (EOD). EOD in CLOs is a much more severe event and is not expected to occur often, even in this environment (except in cases of manager fraud or negligence).

O/C tests are one standard measure of credit support for CLO liabilities with ratings from Standard & Poor's Ratings Services. They track the ratio of performing and nonperforming assets to liabilities for specific CLO debt classes. A CLO will typically have multiple O/C tests that correspond to different classes of rated debt. An O/C test breach generally causes the redirection of cash flow toward the repayment of the senior CLO classes and the "lock-out" of payments that would otherwise flow to the manager in the form of "subordinated management fees" and distribution to equity investors.
Most CLOs pay both senior and subordinated fees. With the subordinated fees cut off, the manager is forced to survive on senior fees alone (15-20 bp). It’s hard to run a credit business on senior fees (having to track 150+ credits in the portfolio) and managers begin gutting their operations and staff.

The paper discusses other problems, such as the need to sell lower rated assets to defend the OC – pressuring the pricing on those assets.

The managers also play games with “discounted obligations” - assets with a purchase price below a certain level like $80. If you buy a loan at $79, it gets market value treatment when “valuing” the collateral. At $81, it gets par treatment. Therefore by buying a loan at $81, you are “adding” $19 to the collateral “value”. This trick - perfectly OK under the indentures - is called OC building.

The overall issue is that senior debt holders' and the managers’ incentives are at conflict. Managers are far less focused on the CLOs’ long-term ability to pay its obligations and are instead concentrating on short-term survival.

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