Los Angeles-based asset management firm Trust Company of the West - the world's largest CDO manager - is preparing to become a classroom of sorts. In the coming months, TCW will open its doors to a group of Chinese investors interested in learning about CDO management so that they can emulate it. The arrangement will prove beneficial to TCW because the CDO manager, along with a growing number of U.S. CDO market participants, are touting the introduction of CDO technology to Asia's rapidly growing economies as one of this year's largest developments.
Call it Manifest Destiny: Part Deux. As Western culture continues to march East - for better or worse bringing with it Britney Spears, K-Fed, Abercrombie & Fitch and McDonalds - U.S. and European markets are drumming their fingers in anticipation of heightened consumer spending and corporate growth further exerting their influence on Asia. To that end, U.S. asset manager Cohen & Co. recently announced its official expansion into Asia with the opening of Cohen Asia, and a handful of U.S. managers are working on joint ventures with local managers inside China and throughout ex-Japan Asia in order to drum up CDO deal volume.
The development of the CDO market in China that started with the government's general reform agenda aims to make the financial sector more market oriented, said Shirley Zheng, a senior vice president at TCW who has spent much of her time recently on the ground in Asia. Aside from regulatory reform, it is widely expected that joint ventures will spur the first wave of issuance - and demand is not expected to be a problem. Indeed, Asian investors for years have ranked among the largest buyers of CDOs backed by U.S. mortgages, corporate loans and bonds. They've helped pump air into the U.S. housing market, lining the wallets of U.S. homeowners with cash, and, in the process, become quite familiar with CDOs technology.
Several balance sheet CLOs backed by corporate loans are expected in China in 2007, and at least one will be a joint venture with a U.S. company, according to a source close to the deal. And while CDO issuance is expected to pick up steam throughout ex-Japan Asia this year, the development in regulation-riddled China is particularly groundbreaking, those involved with the efforts said.
That is, once all of the elements are in place to efficiently securitize the country's massive pool of assets. "You have a lot of people talking about China, and a lot of people talking about India as well, but you can't really get any detailed projections," said one source close to the matter. "Common sense will say securitization will take off. Whether it is loans, receivables, ABS - there are always underlying assets. Someway, somehow, someone will decide to pull all those exposures together."
Elsewhere in ex-Japan Asia, Basel II is expected to diversify what has been a largely synthetic market, as commercial banks look to free up their balance sheets by issuing balance sheet CLOs. As for synthetics, increasing interest in exposure to spread and market risk - particularly in Hong Kong and Singapore - is expected to bolster issuance of more complex products, such as CPDOs and commodity-linked CDOs, or CCOs.
China CDO prospects in 2007
While the degree of certainty that CLOs will close in China this year is not nearly as high as it is in the rest of ex-Japan Asia, the sheer size of the pool of loans in the country available for securitization causes a number of yield-starved investors to salivate. Some are nearly positive at least one CLO will close in China this year, while others remain skeptical that the country's notorious regulatory atmosphere could snuff out the chance of any new deals.
"CDOs are still something that is fairly unknown for the regulators, so it has been fairly difficult. I don't see that China will be very different," one Asian asset manager said.
Those anticipating deals this year, however, point to China's own motivation to do so, the undeniable investor interest in the products - and the need of particularly small and midsize banks to increase funding options. Of course, there is also the driving force of interest on behalf of U.S. institutions in search of yield. "It will happen, but whether it happens in the near term is the question," said Angus Duncan, a partner in Cadwalader, Wickersham & Taft's London office. Duncan said while there is more likelihood for a balance sheet deal to be completed, it is unclear whether there are enough assets available to complete an arbitrage transaction.
"China is deliberate in terms of doing these transactions," said Patrick Tadie, a managing director at Bank of New York. "It will take some time for investors to get as comfortable with these types of transactions as they have in other countries." Tadie added, however, that CDO technology appears to have spread to Asia and Australia at a "much more rapid pace" than it did from the U.S. to Europe.
China's interest in securitization goes back to 1998, when the then-prime minister wrote of his support in an internal memo. An approval came forward in 2004 for a pilot program to test securitization, which finally bore fruit with the long-anticipated pilot programs CDB 2005-1 CLO and CCB 2005-1 RMBS, which were simultaneously launched near the end of 2005. Chinese regulatory authorities submitted a positive report in April 2006 to China's State Council, helping to clear the way for more issuance, according to Derivative Fitch. But even so, any securitization is likely to face time-consuming government scrutiny on a case-by-case basis, some said.
China is motivated to gain experience in securitization for the reasons any company would be interested in doing so - to prepare for long-term use of the funding source, adjust its asset and liability structure and expand the array of funding resources. According to Fitch, policy banks and midsize banks are particularly in need of accessing more funding. And once CDO technology picks up in Asia, it is likely to stick around, market participants say. "It is a technology, not a product that will come in and disappear for a while," Zheng said.
CLO issuance in China will likely consist of both performing and nonperforming loans, Zheng said. "The major banks have a great deal of them from the past, and at this point, the legal framework there is somewhat mature enough to allow structures to put together CLO transactions backed by nonperforming loans." The natural investor for the CLOs is expected to be local, according to Zheng, at least initially. The majority of the banks will issue balance sheet CLOs and retain the equity tranche.
Prospects in ex-Japan Asia
Roughly $21 billion of CDO issuance came from Asia last year, according to data compiled by JPMorgan Securities. The investment bank is projecting an overall 19% increase in issuance this year, to $25 billion. CDOs backed by high yield loans accounted for nearly $13 billion in 2006, with balance sheet deals accounting for about $12 billion of the total. JPMorgan is anticipating a 20% rise in balance sheet CLO issuance in Asia in 2007. Not surprisingly, structured finance CDO issuance accounted for only $300 million in issuance, comprising $100 million in the high grade CDO category and $100 million in the CDO squared category. CDOs backed by investment-grade debt and high yield bonds accounted for $4.8 million and $3.2 million in issuance last year, respectively, and are each projected to grow by 20% this year, according to JPMorgan projections.
Even though regulatory issues, collateral constraints and investor sentiment vary across ex-Japan Asia, market participants are expecting two main themes to emerge in 2007: continued development of synthetic products and an increase in cash deals as commercial banks look to lift credit risk from their balance sheets.
In Hong Kong and Singapore, sources say investors are growing increasingly interested in more exotic products, such as CPDOs and commodity-linked CDOs. The move marks a push not only into more complex product types, but a different type of risk, said Dipesh Patel, a director at Derivative Fitch in Hong Kong. Unlike the mainstay in the area, single tranche bespoke synthetic CDOs, the new, more complex structures expose investors to market and spread risk.
Korea is also interested in developing a domestic CDS market, a possibility that could mean even more demand for complex structured products. "You have Asian investors wanting to purchase innovative complex products and at the same time you have investors in the U.S. and Europe wanting more Asian exposure," Patel said.
While a number of CDOs have been issued out of Hong Kong, Singapore's government is currently considering incentives that would promote an increase in CDO issuance, according to a source close to the situation. As in China, the pairing of U.S. asset managers with local managers is expected. In 2005, United Overseas Bank Group's asset management arm, one of three Singapore-based asset managers, announced with Citigroup the closing of the largest ABS CDO managed by an Asian manager. Raffles Place Funding, at just over US$1 billion, was well received by investors, according to Citi. This is a sign that Asian investors are interested in buying from local managers. While UOBAM's ABS CDO deals have been backed primarily by U.S. assets, the firm is interested in including an increasing number of locally originated assets once the market becomes more liquid. It plans to bring as many as four deals to the market this year.
Additionally, one Singapore-based asset manager has already issued a CDO equity fund, and another is considering the option. Overall, however, corporate loans and bonds are widely expected as the product of choice in Asia this year, as the local ABS market is not deep enough to support CDO technology. Even sourcing synthetically, the legal framework for the assets and operational implications have not been worked out, Zheng of TCW said. Asian investors are also not as comfortable with ABS transactions as they are with the more straightforward structure of corporate loans and bonds, one source said. It is an area managers are watching closely, as the desire to put together deals backed by local collateral is high. "Asian collateral is increasing very rapidly, especially in CMBS," said one source.
The implementation of Basel II is expected to result in a number of cash balance sheet CLO deals, particularly in Taiwan. While Taiwan has seen a fair number of CBOs, the need for banks to free up their balance sheets is expected to have a particular impact in the region. "Some domestic banks in Taiwan have exhausted their lending capacity for certain sectors and obligors," Patel said.
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