Not unlike a brand new car, a CDO's price plummets as soon as it leaves the lot, its value depreciating instantly in a thin secondary market. To make matters worse, dealers have been marking-to-market CDOs at unprecedentedly wide levels on average versus purchase price - to the chagrin of investors, sources say.

While this controversy was around years before the Sept. 11 attacks, the Street has become more conservative in its financial reporting and subsequently on the marks or bids made on clients' portfolios.

"Quarter four is the time of year when dealers want to be light on inventory and the widening mark-to-market demonstrates the reality of the illiquidity of the CDO secondary market," said Anthony Thompson, a managing director and CDO researcher at Deutsche Bank Alex. Brown.

To their consternation, several investors are seeing healthy, confirmed triple-A arbitrage cash CDOs from upper-tier collateral managers, purchased in the low 40s, marked at about 60 basis points over Libor by dealers.

For example, one recent arbitrage cashflow CDO that printed at 42 basis points over Libor was almost immediately marked at 60 basis points over Libor. An 18-basis-point gap between a purchase level and a sale could result in a significant loss to a bondholder, should the investor liquidate the position.

"Most likely the dealer owns a sizeable amount of the given CDO and for their own risk-management purposes, they need to mark the bond back to 60 basis to cover their butts," noted one analyst at a leading CDO underwriter. Another reason for the wide marks is that it is very difficult to get a CDO bid from dealers that have not underwritten the transaction.

"CDOs are primarily a buy-and-hold product and a mark to market spread is the price some have to pay for owning an illiquid product," said one senior managing director at a bulge-bracket bank.

Relative Value

Several triple-A investors with securities arbitrage conduits that mark their books regularly are frustrated with the wide marks and have begun to diversify away from CDOs, which is typically capped at about 20%-25% of a typical arbitrage conduit's par amount.

Meanwhile, since Sept. 11, off-the-run U.S. dollar lease deals have been offered at levels comparable to CDOs at far shorter average lives, and there are plenty of bargains in the corporate market.

So if many older conduits are filling up on CDO paper, and getting skittish, then who is buying the triple-As? New SIVs ramping-up, sources said. ASR/IFR Asset-Backed Securities has identified at least nine.

Additionally, hedge funds also have been buying triple-A paper.

Nevertheless, the selling is not getting any easier and recent tight CDO pricings have benefited from a clear lack of supply. It's said that many deals have hit a roadblock in placing equity and mostly top-tier, repeat issuers have come to market since Sept. 11. According to one source, Northern European bank investors (without conduits) are out of the market almost completely, while insurance companies have scaled back their purchases following American Express' accounting rule write-down of several hundred million dollars associated with CDO.

2001 CDO vintage: Buy now?

Still, CDO investor demand post Sept. 11 has been stronger than expected. Tier-1 triple-A rated arbitrage high-yield and bank-loan deals appear to have found comfort in the Libor plus 43 to 45 basis point range, although triple-Bs are frequently being seen in the 260 basis points over Libor range. However, investors and analysts expect spreads to widen further as the economy continues to weaken and triple-As could reach a 50 basis point average spread level.

The high-yield sector needs some good news, and Moody's Investors Service may have some. A peak in speculative-grade defaults at 10.2%, likely in February 2002, then a decline to 9.4% by September 2002. If this is the case, the current high-yield premiums, at record wide levels, should give recently issued CDOs the necessary breathing room to perform better than comparable paper issued in a lower spread environment, says DB's Thompson.

Dealers flock to CDOs

Given the furious pace of downgraded CDOs one would expect not just investors to exit the business.

However, entities such as Banc of America, Greenwich Capital Markets, Barclays Capital, Soc Gen, Banc One, Links Securities, among others have made expensive hires to build a visible CDO business since 2000. Further, at least one Japanese and a couple European banks are looking to hire a head of CDOs to start an underwriting business in the sector.

"Dealers are realizing that to be a player in the capital markets you have to have a CDO businesses," said an MD at a top ranked CDO underwriter.

When you start matters

Because dealers who have entered the market within the last two years missed the problem cohorts of the late 1990s, those underwriters will be able to bring tighter deals, explained one banker.

"Investors associate dealers with troubled transactions, so when you have irate customers, it makes it much more difficult to sell bonds to them at tighter prices than some of your competitors with a cleaner track record," the banker said.

For example, deals underwritten by Bear Stearns have tended to price slightly wider than those from Credit Suisse First Boston recently, said one source. Bear underwrote CDOs heavily throughout the late 1990s, vintages that continue to get hammered by the rating agencies. CSFB, on the other hand, kicked off its CDO business in the 2000 cohort, which has been a relatively healthy vintage thus far, helping CSFB capitalize on its structuring reputation without the same tests other dealers have faced.

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