No shelter

Increasing downgrades, falling prices of leveraged loans and rising defaults are beginning to trouble the once sheltered world of collateralized loan obligations. Indeed, several loan market participants have begun to worry that stress among these vehicles could soon create severe problems for credit markets.

"The real question is, which [CLO] deals are going to default," says Deborah Festa, a partner in O'Melveny & Myers LLP, referring to the big issue facing structured vehicles that accounted for roughly 66% of demand for leveraged loans during the credit boom.

CLOs are pools of money that buy loans from banks. They are tranched according to seniority, with equity investments at the bottom. The highest tranches, rated AAA, make up the lion's share of the money and receive the most protection.

The prospect of CLO defaults is causing consternation in the loan market, not because of the unlikely possibility of mass loan portfolio liquidations, but because defaults could cause CLOs to freeze reinvestment of their money into new loans, which will severely hamper the refinancing of a bulge of loan maturities that will hit the market between 2012 and 2014.

"The potential is definitely there for a large problem," says Wachovia Securities LLC analyst David Preston.

For CLOs, the central issue is the prospect of breaching so-called overcollateralization tests. These are meant to ensure that lenders to CLOs are protected against defaults in the loan portfolios that secure their tranches. Typically, this means CLO managers must keep the value of portfolios at around 120% to 125% of the value of their liabilities. If, for example, a CLO has collected $100 in its senior and subordinated debt tranches, it must maintain a loan portfolio worth $120 to $125 to give investors a cushion.

As the value of the loans falls, the funds breach their OC tests, which forces CLO managers to divert payments that normally would flow through the senior to subordinate tranches and finally to the equity to pay back their lenders. This reduces the amount of debt on the CLO and in theory allows the funds to come back into compliance with their OC tests (a reduction in liabilities would eventually match the reduction in the value of the assets). However, this also has the effect of diverting CLO funds that would otherwise have been available to reinvest in new loans and reduces the amount of money available to the market and, ultimately, to borrowers.

In severe cases, a drop in the OC ratio below 102% causes an "event of default," which allows creditors to accelerate payments on their debt and puts the CLO in permanent runoff mode, effectively shutting it down.

In a booming loan market, meeting OC tests was easy. But now, with the market value of loans falling sharply and an increasing number of loans being downgraded (the complex valuation formulae used by CLOs discounts the value of debt-rated CCC, making it more difficult to meet OC tests as the number of CCC-rated loans in a portfolio rises), an increasing number of CLOs are facing default.

According to Preston, about half of the CLOs created after 2002 will be in OC-test-based default by the end of 2011. His report actually contemplates a worst-case 87% default rate among CLOs by the end of next year.

Standard & Poor's Leveraged Commentary & Data unit reports that about $203 billion in leveraged loans are set to mature in 2014, compared with $26.5 billion in 2011. If those maturing loans can't be refinanced, they may default, an uncomfortable prospect for credit market participants.

As Preston put it in a March 23 research note: "As CLOs purchased approximately two-thirds of loans from 2003-2007, these loans may face difficulty refinancing without a CLO market. Just as mortgage defaults rose and recoveries fell due to option ARM borrowers with limited refinancing opportunities, loan cumulative losses could spike if the market is not revived by 2012-2014."

As if today's problems weren't enough to worry over.