If you want to hear investors complain, ask them where their dealers are marking their CDO positions. On a cashflow basis, a deal might be yielding its expected return, but its value may bleed when marked-to-market. Unfortunately, investors have to explain to their management that this is just "part of the game." From a buy-and-hold perspective, this was a good economic investment.

After all, a car drops in value 25% as soon as you drive it off the lot. Add in a dented fender or a double-A rated tranche nicked to triple-B, and there goes the LASIK surgery you were saving up for.

"To point the finger in the other direction, the investors are the first to demand steep discounts citing the same conservative assumptions we bankers use to give the marks," says one CDO department head. Some of those conservative assumptions are that the deal may get re-rated and downgraded by one of the three rating agencies or a large premium will be demanded because it is a secondary position. The list goes on. CDOs that have had shown rating volatility find their dealer marks can vary by a whole percentage point.

Frustrating investors further are comparisons to more liquid markets such as MBS. "When I was a mortgage trader, if you gave a mark one day on a MBS security in a client's portfolio, you better be damn sure that your bid the following day wasn't off by a handful of basis points," said one CDO banker. However, mortgage backeds - especially on the commercial side - are homogenous assets, whereas CDOs are credit specific. There is a tremendous asset manager bias and structures vary.

In the derivative CDO world, investors report that even clean new issue triple-A paper can see portfolio marks back by between 15 basis points and 20 basis points from original coupons. In the non-theoretical trading world, it is not uncommon for a bid/ask spread to gap as wide as five to ten percent on subordinate tranches that have seen problems. For example, the following are approximate levels on where partially compliant cash flow CDOs trade over Libor (see Lehman table to compare to new issue spreads): triple-A +100, double-A +200, single-A +250, triple-B 12% to 14% yield, double-B 15% to 17% yield (all depend on leverage).

"CDOs are a very wide bid/ask spread market that makes transacting challenging," explains Jon Prestley, vice president of ABS at the Hartford Investment Management Company. "Usually there is a very big gap between what the holder believes the intrinsic value is and what the market is willing to pay, especially if there is any hint of distress in the deal."

The gaps between the primary market and secondary market are largely because pricing is based on a myriad of assumptions and inconsistent modeling, culminating in what one securitization accountant calls "highly imperfect information to transact with."

Some hope the proliferation of modeling agents that are offering CDO valuing software will allow improved liquidity and transparency down the line. The list of products includes Bear Stearns' BondStudio/FASTrader, CDOVantage, DM Partners/FCS (Wall Street Office), Intex, Wall Street Analytics.

"Having modeled deals available on a common third party platform, where everyone is looking at the same cash flows and can agree on the assumptions will happen eventually," noted one head of CDOs.

"If you have sophisticated software that gives you a price on a CDO tranche that no one will trade on, then all you have is an academic number," the banker continued. "Our firm uses models, pricing services, and subjective knowledge of where bonds are clearing in the market to give our clients evaluation marks. You cannot ignore the trading value if the point is to see what someone would be willing to pay for the security."

Traders and some investors note that the evaluation marks CDO holders want at times are below the economic value of the equity, particularly when it comes to cashflow high-yield CBOs where a triple-B credit in the pool might trade at 25 cents on the dollar at one day from default. Arb cashflow high-yield CBOs in the 1997-1998 vintage have an average Caa' bucket of 14%, according to CDO Indices from Moody's Investors Service. There are no rules in these structures stipulating that deeply discounted securities need to be disclosed. An investor would have to know the current price of each security in the pool. Thus, a complexity premium is priced into any CDO from a buyer, particularly in more seasoned deals.

Nevertheless, several investors feel dealers are inconsistent and unfair. "Some dealers are marking positions extremely low, while others are marking way too optimistically," said a portfolio manager that buys distressed CDOs. "The only thing that I think investors can do is to have the underwriter explain its methodology for marking a particular bond and push for adjustments when necessary; some dealers will comply while others will continue to mark in a manner that is pretty incomprehensible. On the other hand while the illiquidity and wide ranging marks may be frustrating, great opportunities can come out of these inefficiencies as well."

The prevailing assumption is that all CDO investors are buying and holding, therefore if a position is in the secondary market there must be something wrong with it. Nevertheless, not all-secondary CDO paper is tainted. It is not uncommon for at least one tranche to not fully clear on a new issue CDO, for various reasons

Sources report that most underwriters are willing to retain up to their approximate $5 million in management fees in CDO equity, but for the debt tranches what they don't sell right away they will need to clear eventually. While not all secondary CDO paper is distressed, it is true the majority seen offered in the secondary market has what the Street calls "hair."

These leftover CDOs can be quite cheap. For example, in one CDO that priced in December 2001 - a time of year when most investors have closed their books - the dealer mysteriously placed the triple-A class at 50 basis points over three-month Libor (10-year weighted average life) right inline with repeat issuers at more liquid times of the year. Few were surprised to see that same deal reappear one month later 11 basis points wider on the triple-A class.

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