NEW YORK - The CDO market is embroiled in an ongoing battle for collateral, and to the consternation of investors, the food fight has forced some managers to seek out alternative solutions, according to delegates at Information Management Network's CDO and Credit Derivatives conference held here last week.
Indeed, "collateral scarcity" was the bugbear of the day. "There are still leverage loans and other CDO collateral being created, but the spreads are tightening to the point where the arbitrage is becoming less compelling," said James Finkel of Dynamic Credit Partners.
Consequently, some leveraged-loan managers are creating buckets of 10% to 15% non-leveraged-loan collateral. There are some rumblings over the inability of these specialized managers to tailor to the needs of their clients, sources said. Moreover, some question what impact the spread war has had on the quality of the end product. "Two years ago, if you wanted a CDO with bank loans, you went and bought bank loans. Today you have to fight for it, and so maybe you buy something that is not quite as good as what you would have bought," said one market source, adding that it would be three or four years before cracks might start showing.
While some fret over just how tight spreads can get in the hunt for collateral - as well as what impact further tightening will have on the ability to bring deals to market - event risk looms on the flip side of the spread equation. "People are worried about the mark-to-market loss on the current tight spread paper they are buying," Finkel said. "There is no great way to hedge credit risk in cash CDOs, and people are generally one-directionally positioned."
The move toward real estate collateral during the past six months could also be cause for concern in some transactions. "These deals are very exposed to the real estate sector, and nobody really knows how correlated the market is, whether it be between commercial and residential, or triple-net-lease," a source said. Moreover, while many in the market eschew the notion of a major housing bubble, the commercial real estate sector is more complicated, sources said.
"The way [commercial real estate] lending has evolved makes it a much different environment than we had seven years ago, when commercial loans were being made on a lower leverage basis," a source said.
Chalk it up to experience?
The growth in the CDO market has spawned a new generation of collateral mangers, which has led some to question their qualifications. "If you can spell CDO, you can issue one," said Sergei Zagin, a director at Wachovia Securities, during a panel discussion, adding that new managers in the leveraged-loan sector are often more familiar with the assets than some of the new managers in the structured finance space.
The difference will become clear in the event of a downturn, which most of the deals being done now will likely experience, Zagin said.
However, historical data in the CDO sector does not necessarily support this claim, sources note. "In all fairness, some new managers have done very well in the past. There doesn't appear to be much of a correlation between being a new manager and doing well," one market observer said.
Additionally, deals are thoroughly vetted by the rating agencies and the arrangers by the time they make it to the investor. "It's not as if a garage mechanic is going to come out and do a CDO," a source said.
"The important questions for a new manager are does the firm have the resources and the focus. Being small and evolving does not necessarily contradict that," said Dynamic Credit's Finkel.
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