The dislocation in the CDO market right now has posed a number of challenges for CDO managers trying to balance higher returns with palatable risk characteristics. However, there is slow to almost nonexistent activity in ABS CDO new issuance, and collateral is trading well below its intrinsic value. As a result, CDO managers have recently been confined to surveillance.
Historically, CDO managers have been able to add value by trading out of collateral that is too rich and buying paper on the cheaper side. However, given the market's heightened sensitivity to risk, sources have noted that almost everything is being bid to a worst-case scenario. This makes it hard to add any value, as far as selling off collateral, when trades are below their underlying value, according to some CDO managers.
"Right now, during this market dislocation, the ability for managers to add value is severely limited just because everything is being beaten up indiscriminately," said James Grady, senior portfolio manager for structured financed securities at Deutsche Asset Management. "Bids are dramatically lower than what fundamentals warrant at this point, and we need a little bit more balance in the market and a little bit more rationality before there will be the opportunity for managers to make some change to their portfolios."
CDO shops expected to take the hardest beating are the deal managers, which have popped up over the last several years and have a sole focus on CDOs as a source of revenue. In turn, managers with a more diverse set of assets - for example, mutual funds and institutional and insurance money - are expected to be the ones to weather the storm.
"Investors right now are looking for managers who have a diverse background and are not dependent on the CDO market in order to ensure that in times like this, when the CDO market is not open, they have other businesses that will be there to sustain them," Grady said.
The smaller CDO-only shops are currently facing the possibility of eventually being driven out of business, leaving the future of their existing portfolio management up in the air. Consolidation is also a topic in the market, with the possibility of independent CDO managers being scooped up by larger organizations or having to consolidate among themselves.
Down and Out
With the lack of ability to ramp new funds in the market - CDO sales are down to $9.1 billion this month from $42 billion in June, according to a recent JPMorgan Securities report - attention has shifted to the surveillance process.
Cohen & Co. recently launched a CDO portfolio management system called Synergy, which is expected to enhance the firm's investment, surveillance and investor reporting processes (ASR, 7/23/07). The new technology will allow managers to view their positions for each CDO alongside security performance information that is automatically updated nightly. The product also features an increased search capability, including the ability to examine all exposures to a particular servicer while displaying the current loss for each such security and the delinquency rates on the underlying pool.
While the platform's launch - amid heightened market concern - was not a result of the weakening ABS CDO market, it is certainly a timely launch, said Steven D'Agostino, Cohen's chief technology officer. "It is certainly an interesting time to be talking about CDO surveillance. We have been building this system for a little while now - since the middle of 2006 - and not particularly because of anything in the ABS CDO market. We have been, for a while now, committed to the idea that we need to invest significant resources to the development of the technology because it is such a big business."
The technology was, however, partly a result of investor demand. "The more business you put on, the more you have to field requests from investors about different transactions you have under management, so in some sense this is a response to that inquiry and our own need to manage this business," D'Agostino said.
A Good Pick
What has been and will continue to be even more important to investors outside of surveillance is the process of selecting what's going into a CDO portfolio. An increasing number of investors have turned to static pools, one market participant noted, since investors know what they are buying into up front. And they can avoid asset classes they do not feel comfortable with - subprime for example. Further, given the weak trading environment, managers have not been able to add additional value after the deal closes, which has previously been an attraction of managed CDOs.
Despite the increasing popularity of static pools, many would still argue that investors are better served having an actively managed portfolio that has the ability to sell out of collateral based on deterioration beyond expectations.
Ideally managers are doing a lot of credit work, increasing their surveillance and identifying weakness ahead of time and selling out of troubled positions before the market recognizes it. "This dislocation happened so quickly it was hard for some managers to do that," Deutsche's Grady said.
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