Three-quarters of CLOs could hit event of default, says Wachovia

In a new research report entitled "CDO liquidations: how likely?" Wachovia calculates that almost all CLOs will breach their most senior overcollateralisation test by the first quarter of 2010. The bank's researchers project loan defaults and downgrades under four different scenarios, but even under the most benign scenario, the average senior OC cushion of 9% was not enough to withstand the defaults and downgrades to triple C.

Assuming that all CLOs have an event of default trigger based on overcollateralisation - and that this test includes haircuts for triple C assets - then 75% of the deals in Wachovia's sample would suffer an event of default.

However, the report's authors Dave Preston and Justin Pauley point out that mass CLO liquidations are unlikely. This is because not all CLOs have OC-based event of default triggers, some of these triggers do not take account of triple C buckets and, even when a deal hits an event of default, liquidations may not be common.

At least half of CLOs do not allow for the senior class to unilaterally liquidate the deal and wipe out junior investors. Furthermore, senior investors may see more value in accelerating the cashflows than liquidating. The report points out that many of the structures that tripped market value triggers in 2008 did not liquidate.

Senior OC cushion in CLOs

Source: Wachovia