As collateral managers continue searching for juicier arbitrage, raw assets, such as unrated commercial whole loans, could be the next target for innovative collateralized debt obligations, with the first deals hitting the market first quarter 2001.

Other potential targets include home-equity loans, equipment leases or franchise loans. Just about any other asset type currently securitized in the ABS market is ripe for these CDOs, if they start getting done, sources said.

"It's almost like combining conventional securitization into the CDO itself," said Steven Kolyer, a partner at Clifford Chance Rogers & Wells. "Normally what goes into CDOs are tradeable, existing securities and bank loans. Now there is an increased interest in including raw financial assets.'"

While there has been interest in whole loan CDOs for at least the last six months, analysts at Standards & Poor's Ratings Services said concrete proposals have only begun emerging within the last few weeks.

"We know of at least one deal where a banker is looking to do a substantial amount of whole loans as collateral within a CBO vehicle," said Kenneth Cheng, an associate director at S&P.

Cheng said that the credit analysis required for the whole loan or other raw financial asset CDO does not fit with the agency's current CDO criteria.

"We're in the process of working on the criteria," he said. "We'll definitely get there, but our current criteria is not conducive to it."

Issues For the Agencies

One of the main issues for S&P in rating a CDO backed by whole loans is that the loans are not rated.

"So for a commercial whole loan, what we envision currently, though it's still in the works, is that we would work in conjunction with our CMBS folks, and they would have to rate the individual loans," Cheng said.

Another issue is that the recovery levels for individual whole loans would be different than a security backed by a pool of loans.

"The problem is that there's no secondary market," said Brian Gordon, a director at Fitch, which has also been looking at several arbitrage deals in the works. "We generally assume that if something defaults, it's sold in the secondary market. But if there's no secondary market for it, there's certainly not going to be a secondary market for it when it's defaulted, and even if there is, it will be for pennies on the dollar. You'd have to change how you'd do your recovery assumption."

Fitch's Richard Hrvatin agreed illiquidity was a major concern from the ratings perspective, especially if the deal were a market value CDO, where the manager is required to trade in and out of positions frequently.

Hrvatin said that Fitch has already rated at least one market value CDO for jumbo prime loan originator First Republic Bank. The deal includes a small basket for whole loans, though that collateral manager has yet to exercise the option.

"They wanted the ability to include some whole loans in their portfolio of mortgage-backed and asset-backed securities," Hrvatin said.

Also, like S&P, for a raw asset such as a commercial whole loan, Fitch would bring on an analyst from its mortgage group to work on a credit/subordination analysis, Hrvatin said.

The Dash for Arbitrage

"Right now the arbitrage touted as being the best is ABS/MBS, but then there's a whole crowd of people looking for that, all peddling leveraged structures to a limited world of equity investors out there," one market source said. "The question is then, how much equity investor capacity is there to support all these efforts?"

Managers are looking for juicier arbitrage as a way to lure the equity investor, which is a primary driver for CDOs of fresh, illiquid assets, such as the raw financial asset, the source said.

"During the summer, home-equity loans had a bad name because a number of big home equity originators went under," the source said. "However, it's still double-A rated, triple-A rated paper that you can pick up relatively cheaply."

Still, in order to package the raw loan asset, managers are going to have to employ innovative structuring, such as mini-securitizations,' where an asset is securitized internally, while it is put into the CDO.

"You could take a select pool of securitization-type loans, and put them into a pass-through trust, and on the same day, you put the trust certificate into the CDO," Kolyer said. "You'd have a kind of mini-securitization, dumping it right into the CDO."

"Whether doing this really takes off or not really depends on whether or not it's cheaper to do it this way," S&P's Cheng said. "For example, for commercial whole loans, is it cheaper to do it as CMBS? Or is it cheaper to put it in a CDO vehicle?"

Regardless, arbitrage CDOs have demonstrated an inherent quality of rapid evolution. It was just this year that the first deals began repackaging ABS, MBS, CMBS and other structured products.

"The repackaging vehicle per se, at different stages of its development, has permitted the repackaging of different types of assets," said Peter Kambeseles, also an associate director at S&P. "And you could argue that the next natural asset is what you deem as raw assets." -

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