Dominion Bond Rating Service is expecting Canadian conduits to become an increasingly larger player in the CDO market. The rating agency is projecting conduit CDO purchases to grow to 15% to 20% of conduit outstandings next year, up from a currently estimated 7% to 8% share. But, that growth will depend, in part, on conduit and ABCP investor support of the products, which Dominion is trying to drum up.
Dominion analysts traveled to Toronto and Montreal last week to try and alleviate conduit and ABCP investor concern regarding CDO investment. CDOs in the markets wear the stigma of the poorly performing 2001 and 2002 vintages, according to Dominion, but the acceptance of CDO and derivative investment is a concern of the Canadian rating agency.
"The relative lack of participation by Canadian banks is a matter of long-term competitive concern." DBRS analysts wrote in a recent report on the matter, "Failure to participate in this area will only weaken the capabilities, skill set, and ability of Canadian banks to serve large, sophisticated customers and to conduct advanced economic and regulatory capital management and manage their own market and credit risk exposures."
The ability of conduits to purchase CDOs and derivative products will be integral to the growth of Canada's conduit market, said Dominion Managing Director Mark Adams. Canadian conduits' CDO purchasing has lagged behind that of the U.S. market, where about 30% of the instruments purchased are CDOs, according to Adams.
Adams said the rating agency is trying to reform investors who think that all CDOs are inherently high-risk vehicles full of bad assets by educating them on the variety of risk and yield the structures offer. "They haven't seen these instruments up close, and they've heard the stories of what has happened in the past." Adams said. "I think that generally CDOs have had a little bit of a reputation, depending on the cycle and the type of the CDO. The immediate response that people have when they think of a CDO is that of volatility and risk," he added.
The total Canadian conduit market is about $105 billion, with ABCP accounting for $66 billion, Adams said. Growth in the conduit market will hinge, in part, on investor acceptance of conduit investment in leveraged super-senior and synthetic CDOs, simply because of the difficulty involved in obtaining asset-backed securities in the current high-demand marketplace.
"I don't expect that there will be any growth in the market because of ABS or general securitization. If there is growth, it will be through [leveraged super-senior and synthetic CDOs] Adams said.
Canadian conduit buyers over the last two years have invested in junior super senior tranches, the reference of which has an attachment point that is about 0.5% to 1% above the triple-A attachment level. But more recently, Canadian conduits have been purchasing the leveraged super-senior tranches.
Leveraged super-senior transactions are a good investment for conduits because of the remote credit risk profiles, according to DBRS. The leverage in leveraged super senior transactions is external compared with CDO squared transactions, where the leverage is internal. Because the leverage is outside the transaction, spread compression is a matter of the credit premium it receives versus the conduit's cost of funds.
Synthetic transactions are lucrative for conduits because of the ability to create a bespoke transaction without the presence of a full capital structure, as well as the lack of ramp-up risk and wind down risk in the structures.
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