Fitch: CDOs Face Increasing ‘Event of Default’ Risk

Unprecedented negative performance in both the U.S. subprime RMBS and SF CDO sectors will lead to an increasing likelihood of CDO event of defaults (EODs), according to Derivative Fitch in a new report released today.

Derivative Fitch said Monday that it has received two EOD notices to date, with the number likely to increase. SF CDOs and CDO-squared transactions originated in 2006 and this year are the most vulnerable to EODs, according to senior director Beth Nugent, although she said EOD risk does not stop with these vintages.

“The rights and remedies of an event of default are unique to each transaction, therefore investors should properly examine and interpret the documents of their investments in order to fully understand the effects of an event of default,” said Nugent.

“Better understanding of EOD documentation is especially important at this juncture. Should U.S. subprime RMBS performance continue to deteriorate, Derivative Fitch expects to see further collateral downgrades that could put more SF CDOs at risk of triggering event of defaults.”

In an EOD, the controlling class on a transaction can vote to either a) accelerate payments to noteholders or to b) liquidate assets.

For transactions where an EOD has been triggered or is imminent, Derivative Fitch assumes that the controlling class will vote to accelerate note payment. Fitch will model the priority of payments that is affected upon an EOD acceleration in its cash flow analysis. This approach may yield a more favorable credit opinion of the senior notes if the priority of payments directs all interest and principal proceeds to redeem these senior notes. However, if the controlling class does not vote to accelerate or votes to liquidate the transaction, Derivative Fitch will revise its assumptions, which may result in a rating adjustment.

For more information, visit http://www.fitchratings.com.