Of late, the so-called "CDO problem" has gained the momentum of a minor witch hunt, seemingly intent on outing a flawed structure that has cost investors hundreds of millions - most notably an $826 million charge recently announced by American Express. However, market players who've remained close to the CDO universe see the "problem" as more of a simple case of sour grapes.

"My guess is [buyers at American Express] didn't know what they were buying," said one market source. "Somebody gave them a billion dollar allocation to go buy CDOs and they just went out and bought. When you call the Street and say I've got a billion dollars to put to work,' what is it going to show you? All the crap.

"So [buyers at American Express] got all the stuff nobody else wanted from 1997 and 1998 - two difficult years - and then they didn't pay attention to it. A lot of the problems that they're realizing and taking losses for now are problems that people who've been paying attention to the CDO market have known about for years now."

Apparently, enough investors have been paying attention. Despite CDO downgrades of $5.2 billion in the second quarter of 2001 - up from $3.8 billion in the first quarter - and considerable softness in the high-yield market, CDOs of below investment-grade collateral continue to enjoy high investor demand. High-yield CLOs and CBOs made up 45% of new issuance in the first half of 2001.

What - in light of all the recent bad press - keeps them coming? The difference, it seems, is in the vintage.

"There are as many complaints as there are investors," said one sellside source. "But nobody's screaming about particular issues with respect to CDO structures that they want to see changed; those things have been gradually folded in over the last three years. The deals that are getting done today look quite a bit different."

Asset manager selection is much more focused upon now than three years ago, the new EITF 99-20 accounting rule (requiring holdings to be carried at the lower of cost or market value) is coming into play -most problems concerning the 1997 and 1998 vintage have been cleaned up. Most of American Express' losses involve securities from those two years.

"I still view the CDO as an attractive asset class," said one market source. "I think it offers good relative value to other things that are out there, but you need to be diversified across vintage, across collateral managers, across asset quality; you need to make sure that you assess risk properly, and that your default and recovery rate assumptions are appropriate for the underlying collateral.

"The models do work; they do exactly what they're supposed to do. I think the CDO problem' is a blessing. Going forward, I think people will have a better handle on what they actually hold."

If not, the big black birds are circling. Moody's Investors Service pegs the high yield default rates at 8% for June 2001, with rates expected to top out at 10.1% by the first quarter of 2002 - promising news for players in the still-developing distressed-debt CDO market.

The first of the few existing all-distressed-debt CDOs - FleetBoston Financial Corp.'s Ark CLO I - was very well received, with one investor calling it "one of the best values of 2000." Patriarch Partners was the collateral manager on the deal, and is reportedly looking to structure similar trades with other banks going forward.

According to one analyst, "I don't think there's going to be a huge boom in distressed debt CDOs, but I think there will be a couple of deals that get done from a couple of really smart players; that's where I think the interesting opportunities are.

"None of this is a huge surprise," he added. "The issuers, the investors that are paying very close attention to the business, the rating agencies and the investment bankers are saying Okay, let's just wait a couple of weeks for everything to blow over. It'll be business as usual."

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