This liquidation of a Credit Suisse CDO, Adams Square Funding I (which I missed and a reader called to my attention) isn’t significant in financial terms (it had issued less than $500 million in securities) but shows investor lack of faith in the likelihood of recovery in the underlying assets.
In Adam Square’s case, the liquidation was forced by the AAA holders. They decided they were better off taking what they could now, despite the fact that there is likely to be little demand for the CDO’s assets, rather than letting the CDO continue to operate. That suggests that they believed defaults could rise high enough to reduce payments even to the AAA holders. As the Wall Street Journal explains, this is only the second time an event-of-default notice for a CDO has led to a decision to liquidate.
From the Wall Street Journal:
Bond-rating firm Standard & Poor’s said late Tuesday it had been informed that the controlling investors in Adams Square Funding I Ltd., a collateralized-debt obligation, had directed the sale of mortgage-backed securities held by the investment vehicle.
CDOs are investment vehicles that hold pools of mortgages and other assets and issue bonds to investors with different levels of risk and return. The controlling class in a CDO is the group of investors who hold the highest-rated securities issued by the CDO. In some circumstances, they can force liquidation to recoup their investment.
Adams, which had issued $487 million in notes to investors, is managed by Credit Suisse Alternative Capital Inc. S&P was notified Nov. 16. Two weeks earlier, a larger CDO known as Carina notified the rating firm that it was liquidating. As a manager, the Credit Suisse Group unit didn’t suffer losses in the CDO, according to a person familiar with the matter, but it could forgo fees it would have earned for managing the product. It isn’t clear who were the controlling investors that forced the liquidation.
The winding down of CDOs marks a new phase of the mortgage-securities crisis. The liquidations follow “events of default” that occur when certain terms of the CDO are breached. A breach can be caused when rating services like S&P downgrade their assessment of mortgage-backed securities held by the CDOs, undermining their standing as collateral. Since the summer, S&P, a unit of McGraw-Hill Cos., and Moody’s Corp.’s Moody’s Investors Service have slashed ratings on thousands of mortgage-backed securities and CDOs.
Adams’s liquidation notice prompted S&P to slash its ratings on several classes of securities associated with the CDO, some by as much as 18 notches. Two classes of the CDO previously rated triple-A were dropped to junk-bond levels, with one going from triple-A to triple-C-minus, a level associated with a high risk of default.
Such liquidations represent a decision by senior CDO noteholders that the best course is to wind down the CDO by selling underlying assets and keeping the proceeds, a sign of low confidence in the market.
Since mid-October, S&P has received event-of-default notices for 28 such CDOs, ranging in value from $285 million to $2.3 billion. Two have indicated they will proceed to liquidate.