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CLO downgrades: CLO market teeters on the brink

Yet more methodology-tweaking by Moody’s and Standard & Poor’s last month brought the prospect of downgrades to the triple-A tranches of cash CLOs ever closer to reality. Moody’s actions early in the month resulted in nearly 3,600 tranches rated double-A and below of 760 US and European CLOs now facing downgrades. S&P’s new approach envisages a 1.6 notch downgrade for senior triple-As, a 4.3 notch downgrade for junior triple-As and a 5.8 notch downgrade for triple-Bs.

"As usual, the rating agencies are light years too late on this," comments one structured credit expert. "The market has already priced this in." But with downgrades of this magnitude, and the continuing deterioration in underlying loan performance, the market is braced for further turmoil that it can ill afford. "The real fear is the impact of banks being forced to unwind their CLO positions," says one analyst. "Most banks are holding these assets in available-for-sale books, but if they fall below investment grade the risk weighted asset capital requirements under Basle II are severe."

Expectations of defaults

As the agencies get more aggressive, CLO investors are increasingly positioning themselves not just for downgrades but also for defaults. The average triple-C basket in a US CLO is already 11% and many structures are close to breaching their overcollateralization tests (the average triple-C bucket in a CLO ranges from 7.5%

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