In 2001, in the face of a slowing economy, the tragic events on Sept. 11 and the Enron Corp. debacle, not to mention a wave of downgrades, the relatively new CDO sector continued forging ahead as a new structured credit product in the fixed income market. While this year's deal volume is down from 2000, triple-A spreads held firm. The credit curve steepened as mezzanine spreads widened in response to economic and event risks. The secondary market advanced as transparency improved with increased surveillance by dealers and rating agencies alike. Consequently, we see the CDO market continuing on a steady path for 2002, with innovation and transparency leading the way. That said, we present the year in review and some thoughts for 2002.
2001 Issuance: Down
In 2001, the U.S. CDO sector continued on its course of innovation generating new products despite a modest 4% decline to 157 deals. Issuance dollar volume declined 22% to $58 billion, mostly due to fewer cash flow balance sheet deals. Key trends in 2001 include the surge in structured finance (SF) CDOs and synthetic structures, a continuous decline in HY CDOs and a sharp drop in cash flow balance sheet deals.
SF CDOs established permanence in the sector this year. SF CDOs, now at a 26% market share, increased 42% to $15.2 billion from $10.7 billion in 2000. Contributing to this strong growth is a compelling performance history for structured finance assets, including ABS and CMBS, and some structural innovations.
In 2001, synthetic deal count rose from 14 in 2000 to 21 deals. Synthetic arbitrage deals represent over 80% of the synthetic volume while 20% are balance sheet motivated. Factors driving the increase in arbitrage synthetic deals include an attractive cash to credit default swaps spread arbitrage, availability of collateral, and greater diversification achieved in reference pools.
Consistent with a trend we noted last year, cash flow balance sheet CLOs continued to decline: only one deal was done versus six in 2000. This dramatic fall from $12 billion to $827 million in 2001 was primarily driven by the simple and efficient execution of synthetics: five balance sheet CLOs this year were done synthetically.
Another trend is the continuing decline in HY CDOs. In 2001, HY CDO flows fell again by 20% on the heels of a 23% decline in 2000. This underscores high-yield credit concerns and reduced supply. We expect modest HY CBO flows next year, unless defaults decline. The road ahead is likely bumpy for existing HY CBOs as recoveries are volatile in the current environment.
Some other interesting new market developments were observed in 2001 in the U.S. and Europe. In the U.S., new collateral types and compositions appeared in deals, including CDS, trust preferred securities, private equity, and combinations of distressed loans and ABS bonds. In Europe, synthetic CDOs continue to dominate, with the technology applied to an even broader range of collateral including residential whole mortgages, commercial mortgages, aircraft leases, and loans to small to medium sized companies. More interesting was the inclusion of credit default swaps, as much as 45%, in cash flow investment grade CDOs.
Primary Spreads &
In 2001, new issue triple-A spreads for HY CDOs and SF CDOs were comparable to levels in 2000. HY CDO triple-As ranged from L+40 to L+50 basis-points, averaging L+45 basis point, while SF CDOs ranged from L+45 basis-points to L+55 basis-points, averaging L+50 basis-points. Triple-B new issue spreads widened across CDO products by 37~40 basis-points versus last year, resulting in the CDO credit curve steepening. The triple-B spread widening was primarily due to concerns about collateral credit; for IG and SF CDOs, higher leverage is also a concern.
The events of Sept. 11th and concerns about airlines, hotels, and insurance sector alike exacerbated spread widening further down the credit curve. While triple-A spreads were left virtually unchanged, triple-B SF CDO and HY CDO spreads widened 18 basis-points and 24 basis-points respectively. This six basis-points differential in widening may be attributed to the stability of structured finance collateral in SF CDOs despite its higher levered structure.
Tiering continued this year. The market discerns deals by the type and credit quality of collateral, manager and structure. SF CDOs price at a premium to corporate bond deals. We attribute this spread premium to longer legal maturities, the newness of the product, collateral complexity, and higher levered mezzanine bonds. SF CDO triple-As trade four to six basis-points behind HY triple-As. SF CDO triple-Bs price 20 to 30 basis-points wider than HY CDO triple-Bs. We continue to view SF CDOs as good value given the compelling performance history of the underlying collateral.
Within CDO deal types, large institutions and/or seasoned CDO issuers with good track records, continued pricing triple-As at one to four basis-points tighter than their respective "generics". Deals with multiple agency ratings priced tighter than deals with one agency. Rating notching criteria for SF CDO collateral also created demand for Moody's rated mezzanine paper. Pricing for wrapped deals is highly dependent on the shadow rating of the tranches; non-triple-A shadow-rated wrapped paper priced five to 15 basis-points wider than "generic" triple-A paper.
There was marked improvement of liquidity in the secondary market, especially for the senior classes of recent clean deal vintages. Clean discount mezzanine bonds garnered good demand from structured funds such as CDOs of CDOs. Insured seniors from story bonds were also well received by investors. Bonds from distressed transactions remained opportunistic buys as headline risks and their analytical complexity commanded premiums. Greater disclosure and surveillance from dealers and rating agencies contributed to better transparency for the sector. As the transparency improves, so does liquidity.
The Cycle Continues
As of Dec. 13th, 76 CDO deals were downgraded in 2001, up from 31 in 2000; 24% were previously downgraded. By vintage, 66% were 1997 and 1998 vintages, 24% were 1999. The rise in downgrades was mainly due to continued credit erosion of high yield bonds issued in 1997 and 1998. Established surveillance efforts by the rating agencies this year also contributed to this wave of downgrades.
By deal type, it is no surprise that 72% of the 76 deals downgraded in 2001 were HY CBOs. Negative action on synthetics totaled 10 downgrades, including four downgrades due to the Enron bankruptcy. Downgrades in other deal types were fewer: five HY CLOs (7%) and three EM (4%). The St. George CDO Funding I was the only U.S. SF CDO downgraded. The deal's insurer, Commercial Guarantee Assurance, was downgraded, impacting the wrapped CDO class. There was one cash flow balance sheet downgraded.
Sept. 11th and the Enron debacle negatively impacted CDO rating performance, but somewhat temporarily. After the initial shock of Sept. 11th subsided, ratings from the majority of deals that had been put on watch were affirmed. In fact, S&P affirmed 70% of the 30 deals on review, while Fitch affirmed 58% of the 26 deals on watch. It is interesting to note the less than 60-day "quick" turnaround on these affirmations, perhaps a testimony to the diversification and structural benefits of CDOs.
By comparison, the effects of Enron were more limited than 9/11. Synthetic IG deals were impacted due to their relatively higher leverage. To date, six domestic synthetic deals were downgraded, and the impact of Enron has left the outlook of certain IG deals somewhat unclear.
Outlook For 2002
Our forecast for 2002 U.S. CDO new issuance is $60 billion, up 3%~4% from 2001. New product innovations should continue, as the market including the arbitrage, managers and investors evolve. CSFB MAP at 172 basis-points suggests continued SF CDO flows. On the other hand, incremental growth of SF CDO may be constrained by the availability of attractively priced collateral. IG CDO issuance should remain opportunistic. Our pipeline supply for the "big three" core SF CDO, HY CDOs (bonds and loans) and synthetic CDOs (arbitrage and balance sheet) represents 22%, 29% and 24% market shares, respectively by deal count, totaling $13 billion or 40 deals.
Using the negative watch pipeline as a barometer for future downgrades, we highlight the following:
*1997 and 1998 HY CBO deals will likely continue as downgrade candidates.
*Currently, 25% of deals on negative watch are HY CLOs, whereas 9% of the downgrades in 2001 were HY CLOs.
*48% of deals on negative watch are from 1999 and 2000 vintages, and four are 2001 synthetics.
In closing, we think there are opportunities in CDOs for a broad spectrum of investors. Well-structured, diversified deals with good managers offer solid value and relatively sound protection against event risks. We emphasize the importance of deal disclosure, timely surveillance, secondary market and analytical support.
We like structured finance collateral for its consistent and proven performance history and leveraged senior secured loans for their high and stable recoveries. Synthetics, specifically managed synthetic CDS deals, may gain greater acceptance than static pool synthetics. Investment grade CDO issuance will be driven by timing and spread arbitrage, which may be enhanced by using a blended pool of cash positions and credit default swaps.
Note: For details please refer to CSFB's CDO Market Watch Weekly, CDO Ratings Watch, CDO Performance Digest and special studies, including "CDOs Mired by a Cycle of Downgrades"