The rapid development of a secondary CDO market attracted a standing room-only crowd during the Bond Market Association's inaugural CDO conference last Tuesday. Seven traders from leading CDO dealers weighed in on what has been, from some perspectives, a historic year.
Panelists envisioned a future during which an expanded investor base drives liquidity in all parts of the capital structure, from senior and mezzanine portions, to PIK-able and non PIK-able assets, with valuation more easily arrived by all parties involved in secondary trades.
Thanks in large part to the orderly liquidation of a CP conduit from Abbey National Bank earlier in the year, secondary market traders gained an extraordinary amount of experience from a product that, four years ago, may have seen four trades a month.
Collateral managers are paying more attention to secondary activity than ever before, and an increasingly sophisticated and broader investor base is now out scanning for collateral. In addition to dealers from rival firms, insurance companies hedge funds have moved into the market. The latter, armed with experience derived from other product areas, have arrived with credit and structure expertise and are likely to change the nature of the once-sluggish trading game.
"There's upwards of $500 billion in deals, all with different tranche levels and various levels of risk; it's quite an opportunity for them," said moderator Adam Sigel,
of Bear Stearns.
"Geographically, a large number of non-U.S. market buyers is skipping the primary market altogether," and focusing instead on opportunities in the secondary market, said Pete Matousek, from Credit Suisse First Boston.
Noteworthy activity seen this year included trades in senior first and second priority non-PIK-able paper, noted Keith Grimaldi, of UBS Warburg.
With the move toward transparency now a mainstream effort, traders noted additional challenges on the horizon. "The market does not have a good sense of relative value right now," said Grimaldi. "It needs more analysis, which is making its way in. But there still are a lot of opportunities."
"We all have the ability to model, but the next step is for investors to model deals themselves, so you can have a two way conversation [on trades]," said Donald Quinton, of Citigroup Global Markets.
"Much like the mortgage market of the 80s, secondaries are moving toward a valuation metric scenario analysis with multiple paths, a positive step," added Brian Wargon, of Lehman Brothers.
Larger class sizes add stability in a profile of outcomes, agreed David Weeks, of Merrill Lynch. However, the real challenge comes from "buyers who buy it and take it out of the buying universe," Weeks said. "But with the supply being taken out of the market, second priority and mezzanine positions' interest has increased," he noted.
Panelists felt the senior part of the capital structure was currently the most crowded spot in the market. Fortunately, this also adds additional interest in mezzanine portions. Early amortizing seniors are the hardest collateral to find, they noted.
"It's a positive sign that the Abbey senior paper is out of the market...investors will begin to look at the next part of the capital structure," said Ross Heller, of JPMorgan.
One interesting footnote to the bevy of activity this year has been increased interest in "flips," the scooping up of collateral only to trade it out quickly again. Citigroup's Quinton stated he has observed a lot of flips on the senior side this year. Panelists agreed flip trading was not exactly cashing in.
"Certainly calls will increase [for flips]," said Wargon, "because there are strategies you can employ if you have a view on the collateral. But buying a [CDO] bond and selling it two weeks later will only work up to a point. It's not that type of market yet." Traders who flipped usually paid more in spread. Flipping ABS or corporates could make for a better trade in the end, according to Wargon.
A recently published article focusing on an illiquid market lacking transparency, unfairly portrayed the current state of the secondary market, the panel of traders felt. Had the article in question been written two years ago, it would have been appropriate, said Bear Stearn's Sigel. "There's probably more transparency [in the secondary CDO market] than in certain ABS classes," he noted.
"Absolutely, there's much more information between us. A few years ago, it was a black hole," agreed JPMorgan's Heller.