03/25/2011

CDO Liquidations on Downward Trajectory

Look for liquidations of collateralized debt obligations to become less frequent this year, despite an overhang of defaulted transactions that could suggest otherwise.

According to Moody's data going back to the birth of the CDO sector, bondholders in 175 defaulted issues have voted to liquidate — all but two since the start of the credit crisis.

At the same time, investors in 132 issues have cast ballots to accelerate payments on senior notes but have yet to decide whether to unwind the deals' underlying portfolios. And the holders of another 104 defaulted transactions haven't come to any agreements on what steps to take. Combined, they could represent a wave of potential liquidations.

But market players say that's unlikely. Bondholders in most defaulted transactions have had plenty of time to consider their options, and those in a position where liquidation made financial sense and was easy to approve already have moved forward with that process. That leaves deals where resolutions are likely to come slower. “We expect liquidations to continue, but at a slower pace than in recent years,” said Evan Tepper, a senior CDO analyst at Moody's.

The slowdown has already been evident this year, as noteholders in a mere five deals have voted to liquidate since Jan. 1. During the same period in 2010, the tally was 20.

The most recent liquidation vote came March 14, among owners of paper from Merrill Lynch's 2007-vintage Forge ABS High Grade CDO 1.

In many cases, bondholders want to avoid simultaneous asset sales that would flood the market with CDO collateral — mostly subprime mortgage bonds. The idea is that a rush of liquidations would hurt the values of those holdings, and thus eat into the amount of capital they might recover.

Subprime mortgage-bond values recently hit an apparent plateau after climbing since early 2010. The 7-8 year senior pieces of those deals now are trading at an average of 50-60 cents on the dollar.

Another factor stalling liquidations: In many cases, senior bondholders have been unable to convince junior investors to approve the processes. That's because liquidations favor the most-senior positions, as proceeds from portfolio sales flow to them first and often leave nothing for lower tranches. If a defaulted deal is allowed to continue operating as usual, however, junior bondholders sometimes can continue receiving interest payments indefinitely. The upshot is that investors in certain deals are at an impasse in which junior players will budge only if their senior counterparts pay them to do so.

Meanwhile, junior bondholders sometimes view acceleration votes as irrelevant. That tactic halts payments to all but the most-senior notes still outstanding until those securities are paid down, at which point installments flow to the next-highest tranche. But interest payments are cut off for the bottom layers of certain deals as soon as a default occurs anyway — meaning acceleration doesn't change their status.

Some accelerated deals proceed to liquidation within a few months. Others linger in acceleration mode for months or even years with no liquidation occurring.

CDOs are considered in default once they hit certain performance triggers that can vary greatly from deal to deal. There also is a wide variance in what happens after the so-called event of default occurs. Some transactions default when the value of the collateral falls below the outstanding principal on the senior notes, even if no payments are missed. Others default when there is a shortfall in interest distributions. In some cases, only the senior noteholders in a defaulted transaction can vote to liquidate. In others, all investors have a say. Some issues require a simple majority to approve asset sales. Others call for a two-thirds vote.

After exploding during the credit crisis, it has been clear for a while that the worst is over in terms of new defaults. The most recent CDO default took place on Sept. 13, according to Moody's, and the consensus among market players is that most deals at risk of default already have done so. There are only about 200 CDOs left in the market that haven't defaulted, according to Moody's.

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