Moody’s Better CLO Cosmetics

Earlier this week, Moody’s Investor Services announced their intention to remove a significantly severe default probability assumption from its rating model.  The net and immediate effect will be to lift Moody’s ratings of Collateralized Loan Obligation (“CLO”) programs by one notch in the most senior classes of most transactions and by as many as three notches for many junior CLO tranches.

The decision by Moody’s to eliminate the “crisis era” default probability factor of 30% from its methodology should be a tremendous boost for the CLO market, as the relatively strong performance of many existing programs will appear to be rewarded by this upgrade. 

While some bankers argue that the ratings lift will do more harm than good to new CLO issuance activity, we find that a little hard to believe.

While many have recently argued for investors to abandon their traditional over reliance on ratings when making investment decisions, we are on the record suggesting that over time, many investors will revert back to the rating agency evaluation for, at minimum, a significant portion of their decsion-making, if not the majority.  We believe that simply highlighting CLO’s by pulling some classes up into “investment grade” territory will only further illuminate the improved performance and the relative high return that these securities generate.

We can’t see how that will be anything but good for both existing  and new CLO programs.

Interesting that both Fitch and Standard & Poors have decided to take a “wait and see” approach to Moody’s acknowledgement of vastly improved market conditions.  Our guess is that they will not be far behind in recalibrating their own models.  Before anyone cries that “the sky will fall again” if the rating agencies go back to their old ways, just keep in mind that all those that said that the agencies went much too far in their reaction to their ratings of CLO’s two and three years ago (when they were under tremendous pressure to pay for past mistakes) have recently been proved to have been correct.  Many, if not most, CLO’s have performed exceedingly well through the Credit Crisis; a credit to their structuring and the performance of the asset managers involved.

About markferraris
Managing Principal Orchard Street Partners LLC

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