The total affected tranches of the sub-AAA review action include over 3,600 tranches representing more than $100 billion from 760 transactions. Previously, on February 4th Moody's announced it had increased its default probability assumptions for corporate credits in the collateral pools of CLOs by a factor of 30% across all rating categories. In addition, Moody's stated that assets with negative outlooks or that are on review for possible downgrade would be treated as if they had already been downgraded by one or two notches, respectively. In assessing the CLO pools Moody's noted that it would "use revised assumptions that incorporate Moody's expectation that corporate default rates are likely to greatly exceed their historical long-term average and reflect the heightened interdependence of credit markets in the current global economic contraction." Some more color from the report:
Moody's break-even default analysis indicates that the Aaa-rated senior tranche of a typical CLO has enough protection to survive a 50% collateral default rate over the life of the transaction under a 40% recovery rate assumption for a pool of mostly senior secured loans. (See Moody's Special Report titled: CLOs: History, Structure, and Perspectives dated August 1, 2008.) Such levels have not been seen since the Great Depression. By way of comparison, Moody's default rate forecasting model currently projects the five-year cumulative default rate for all speculative-grade corporates at roughly 30% under a baseline scenario and 36% under a pessimistic scenario. (See Moody's Monthly Default Report -- January 2009, dated February 10, 2009.) Moody's does not anticipate changes in the Aaa rating of the senior-most tranches of a typical CLO unless corporate credit conditions deteriorate further and realization of the pessimistic scenario becomes more likely.
Two Stages of CLO Rating Review
Moody's will conduct its CLO ratings review in two stages. In Stage I, which will begin immediately, Moody's will use a parameter-based approach to calibrate the extent of downgrades to tranches currently rated single-A and below in the vast majority of cash flow CLOs. Any senior-most CLO tranches that appear to have significantly weaker than average structures and portfolios may be placed on watch for possible downgrade at that time as well. In Stage II, which is expected to begin at the end of March, Moody's will perform a more comprehensive analysis by modeling each CLO individually. At that time, additional rating actions will be taken as necessary for all rated liabilities, including tranches currently rated Aa and Aaa. Moody's expects to complete Stage II by the end of the second quarter of 2009.
The collateral portfolio characteristics that will be examined as part of Stage I include (1) the current rating, (2) the level of over-collateralization (O/C), (3) the Weighted Average Rating Factor (WARF) transition since mid-2008, (4) the absolute increase in percentage of Caa-rated assets since mid-2008, (5) whether a tranche is currently, or is expected on an upcoming payment date, to pay-in-kind (PIK), and (6) the concentration of structured finance securities, such as other CLOs, in the collateral pool.
This wholesale approach to reevaluating embedded risk is very troubling as for once Moody's chance to impair some assets that may be more viable than its comparable peers but just from being lumped into the same category will get an adversely negative treatment. It is also bad news for GE, which may truly be faced with a very aggressive downgrade, spanning more than one notch, and approaching the critical 3 notch level which would throw the company into a liquidity tailspin. Lastly, the CLO action is bad news, obviously, for CLOs who will have to force-sell any previously held tranches that post the downgrade are no longer eligible for portfolio holdings, and will likely cause a significant ramp up in matched CDS book due to the issue of negative convexity we discussed earlier.