The only places more packed than the CDO sessions at the recent Barcelona conference, noticed one attendee, were the hallways blaring the World Cup. It was standing room only at the six CDO seminars.

ABS pros discussed the reasons behind the nearly 300 ratings downgrades this year, and what the future holds for an instrument that has come under severe and swift stress in 2002.

"The deterioration of credit has been unexpected and steep, and it's been especially problematic for managers who have been unable to get out in time," said Gus Harris, a managing director in the derivatives group at Moody's Investors Service.

In particular, managers have had difficulty reacting to the dizzying fall of WorldCom (see story p.6). Its descent from investment grade to high yield to near bankruptcy has been so swift that its $32 billion of notes now may be widely held by both investment grade and high yield CDOs. "Most deals own the same stuff, you're boxed in as a manager as to what you can buy," said investor Tom Sontag of Strong Asset Management. "It seems to me there's a lot of WorldCom paper in these deals. My guess is it's held pretty extensively by most managers."

To be sure, WorldCom is hardly the only problem for CDOs. Corporate defaults are up across the board and recoveries are down. That said, however, Douglas Lucas of UBS Warburg pointed out that the recent wave of defaults is hardly unprecedented. The 9.4% of corporate defaults in 2001 are considerably less than the 16.2% in 1990 and the 14.6% in 1991.

Lucas therefore puts some of the blame for the raft of CDO downgrades at the feet of rating agencies, which he said have not adjusted their high yield default assumptions since 1989. "They didn't test them at high enough default rates and they have used less conservative assumptions. So you've got no cushion and the managers are under performing the market."

This environment has put "extreme pressure," on managers to protect lower rated tranches, said David Tesher, a managing director at Standard & Poor's. In some cases the managers are buying bonds that the market prices at distressed levels, though, since they are still performing, the managers receive par credit. This is a reemerging development that is gaining a lot of notice from the rating agency.

It's precisely this kind of tactic that worries an investor like Sontag. "You have a case of a conflict of interest between a senior debt holders and the manager," said Sontag. He pointed out that a manager usually gets a piece of the action in the double-B or equity slice, giving him added incentive to rebuild collateral by any means necessary. (While bondholders often cite this conflict of interest, Lucas noted that while CDO managers have a contractual obligation to bondholder, they also have a fiduciary responsibility to equity holders.)

Given this backdrop, industry watchers were at something of a loss to explain why CBO new issuance in 2002 is at the same pace as 2001 (though down from 2000), and why new issue spreads are so much tighter than in the secondary. "Overall I'm fairly negative on the market, and I've got no interest at all in new issues, which are exceedingly rich compared to the secondary market," said Sontag.

While triple-A new issues price at about a 50 basis points over Libor, there's plenty of triple-A notes available in the secondary for 75 to 100 basis points. Helping to prop up pricing in the new issue market, observers speculated, are more triggers to keep cash in the new deals and protect senior bondholders. Also, there is generally more information on a deal when it's being pushed out the gate than when it is in the secondary. On the flip side, a lack of information is driving spreads wider in the secondary is less information as underwriters become less and less supportive.

Finally, there's the desire on the part of investors to cut their losses. "They'd rather take the loss and have it off the books than wait around for years to see if they are worth more," Lucas said. "A lot of investors are desperate to get rid of the stuff. They don't want to answer questions about why they bought it and why they still hold it."

Lest all seem gloom and doom in the CBO world, Moody's Harris noted that downgraded CBOs have clawed their way back before and could do so again. In 1998 and 1999 many emerging market CBOs were downgraded, but in 2000 they began to be upgraded and now most are back to their original rating. While somewhat encouraging, waiting until 2006 may not be feasible, or palatable, for everyone.

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