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CDO Downgrades Signal Market Pain

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By: Steven Marlin | May 12, 2009

The outlook for collateralized debt obligations backed by insurance company assets is looking increasingly shaky, Manny Modu, analyst at A.M. Best, told Markets Media Wednesday.

A.M. Best has placed debt ratings on various senior and mezzanine notes under review with negative implications,

“We see a degradation in ratings in these CDO pools,” said Modu. “There's probably going to be more downgrades than upgrades this year.”

The ratings actions were taken on four multi-tranche CDO notes co-issued by eight special purpose vehicles. The principal balance of the rated notes are collateralized by a pool of securities issued by small to medium-sized U.S. insurance companies. Major considerations in rating the notes included collateral default risk, structural, protection through the waterfall, counterparty swaps protection, and ongoing monitoring of the transaction.

Separately, Standard & Poor's downgraded ratings on 22 tranches from eight U.S. cash flow and hybrid CDOs. Two of the eight are mezzanine structured finance CDOs of asset-backed securities, which are collateralized by mezzanine tranches of residential mortgage-backed securities (RMBS). Four of the eight are high-grade CDOs collateralized by 'AAA' through 'A' rated tranches of RMBS. The other two are CDOs of CDOs.

The downgrades are a reflection of underlying economic conditions rather than of the specific assets underlying the CDOs.

“The downgrade is an indirect response to economic conditions, not a result of an independent valuation that pulls apart the CDO,” Rick Martin, head of technical accounting at Pluris Valuation Advisors, told Markets Media. “Apart from forensic accounting, valuation firms are using models and estimates. Lots of [the underlying assets] are Level 3 assets that have to be modeled out.”