Single-tranche CDOs ride spreading Parmalat downgrades

New Angles

Last year’s newcomer to the collateralised debt obligation market – the single-tranche CDO – may prove to be the most resilient of its breed, as the fallout from Parmalat’s default trickles through the synthetic CDO market, triggering downgrades galore.

Most single-tranche deals are transacted privately between collateral managers and a single investor, and have a greater capability to make substitutions in the reference pool. These deals are considered easier to restructure in the wake of a credit event, because only one investor’s approval need be sought instead of many to make the necessary changes.

“On a mark-to-market basis, the money has been lost, but some kind of restructuring can be done in single-tranche deals,” says the head of exotic credit derivatives at a major European bank.

Not only is it easier to restructure a single-tranche deal, it is prudent to do so from a relationship management perspective. “It’s important to look at a deal post-close,” says Shaun Baddeley, senior director and head of CDO performance analytics at Fitch Ratings in London.

Generally, a collateral manager will substitute a few of the portfolio’s poorly performing names and inject additional equity into a deal and maintain its rating. Restructuring single-tranche, single-investor deals is particularly important, as one downgrade could put the deal beyond an investor’s remit and lead to a complete dissolution of the portfolio.

Baddeley saw a few deals that benefited from restructuring last year – both single-tranche and traditional synthetic CDOs. “Structurers have been doing performance analysis on deals to see if a CDO is under stress and then substituting some names,” he says. Most of the time, rating agencies are amenable to restructurings.

Twenty-two private synthetic CDOs have been put on negative watch for downgrade by Fitch Ratings, and most of those are single-tranche deals. According to Baddeley: “Private deals are the mountain underwater in the synthetic arbitrage market.”

Despite Parmalat being widely referenced in single-tranche deals, the asset class will probably not experience a great deal of ratings volatility. Baddeley anticipates that tranches rated above single-A will only experience a single-notch downgrade as a result of the collapse.

Single-tranche deals are benefiting from being a market segment that evolved over the past year. These debutants are not exposed to credits that defaulted in 2001 and 2002, as is the case with older vintages, and are the beneficiaries of improved structural features.

Perhaps the most important newcomer advantage for the single-tranche market is that, unlike past defaults, Parmalat’s happened without contagion in the form of general spread widening. That was largely due to market sentiment. “At the time of Enron, everyone was very defensive. In this case, investors were looking for positive news,” remarks one credit derivatives expert.

Equity pieces of older-vintage synthetic CDOs are typically held by the dealer community and proprietary trading desks, notes Sivan Mahadevan, head of credit derivatives research at Morgan Stanley in New York. He believes that because Parmalat was always a wide-trading credit, most of the dealers will have hedged their exposures.

Low recovery rates

Hedging won’t save the dealers and prop desks from booking Parmalat-related losses though, because low recovery rates are expected. However, those who did hedge will probably not experience significant losses. Parmalat is trading at roughly 23 cents on the dollar.

As the effects of the Parmalat default continue to filter through the markets, credit analysts are looking for the next blow-up – in particular, domineering family-controlled companies with indebted holding company structures. “We are trying to develop an awareness of the type of issuer that could be the next Parmalat. It might not necessarily be a case of fraud, but more likely, accounting irregularities – such as [Dutch retailer] Ahold,” says one credit analyst.

The Parmalat effect – downgraded CDOs

Fitch Ratings has put 29 securities from 11 public CDOs and 24 tranches from 22 private CDOs on negative credit watch in reaction to the deals’ Parmalat exposure. Moody’s Investors Service has identified 57 European synthetic and four European cashflow CDOs with exposure to Parmalat. Standard & Poor’s has placed the ratings on notes issued by 86 synthetic deals on credit watch with developing implications. Here are the securities downgrades at January 20, 2004:

Deal S&P Moody’s
Scirocco Investments SA, class B
AA to AA–
A2 to A3
Scirocco Investments SA, class C
A to BBB
Baa3 to Ba1
SGA CLN, series 4775
A– to BBB
SGA CLN, series 4931
AA– to BBB+
SGA CLN, series 5143
A– to BBB–
Claris 06-2003
A– to BBB+
Eirles Two, series 22
BBB+ to BBB–
Eirles Two, series 74
Eirles Two, series 70
Eirles Four, series 41
Eirles Four, series 63
Aa2 to A1
Eirles Four, series 44
A to BBB+
Coriolanus Ltd, series 14 AAA to AA
Argon Capital Plc, series 22
B to CCC+
Argon Capital Plc, series 23
BBB– to BB+
Tribune Ltd, series 7
A to BBB+
Arlo Spears
AA to BBB+
CDO Master Investments 2 SA, class A AAA to AA+
Aa1 to Aa3
CDO Master Investments 2 SA, class B
A1 to Baa2
CDO Master Investments 2 SA, class C BBB to BBB–
Ba1 to B1
Petra Capital Ltd class B
A1 to A2
Petra Capital Ltd class C
Baa2 to Baa3
Petra Capital Ltd class D
Ba1 to Ba2
Bifrost Legolas 3 class A
Aaa to Aa1
Bifrost Legolas 3 class B
Aa3 to A1
Bifrost Legolas 3 class C
Aaa to Aa1
Bifrost Legolas 3 class D
Aa3 to A1
Bifrost Legolas 3 class E
Aaa to Aa1
Bifrost Legolas 3 class F
Aa2 to A1
Iliad Investments Plc, class A
Aaa to Aa2
Iliad Investments Plc, class B
Aa3 to A2
Iliad Investments Plc, class C
Baa3 to Ba2
Spice Finance Ltd, series 2001-4
A3 to Ba1
Spice Finance Ltd, series 2003-3
Baa2 to Baa3
Spice Finance Ltd, series 2001-5 A2 to A3

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