NEW YORK - Promoting the long-term health of CDOs was the focus of Standard & Poor's recent CDO conference late last month, the second such event hosted by the ratings agency. As has been a theme over the past year, successful improvement of the market will require a restructuring effort to which all interested parties will need to subscribe.
It became clear to attendees that a picture of CDO longevity can be painted with more than one brush. While improving the credit quality of these vehicles' debt tranches was an obvious focus, discussion surrounded the fact that structural changes need to also stress an increased alignment between CDO asset managers and debt- and equity-tranche investors.
Several recently issued CDOs have already incorporated provisions considered important to sustaining longevity and a quality debt rating. According to S&P, however, not every provision has been incorporated just yet. In the face of this, activity in the CDO market is up substantially from just one year ago. As of June 30, outstanding CDO volume reached $191 billion, according to The Bond Market Association, compared to $167 billion at year-end 2001 - a jump of 14.4%.
The new structuring standards appearing in recently rated CDOs are arguably more of an affirmation of common sense than the breaking of new ground. For example, assets on watch for downgrade must be treated as having already been downgraded one ratings notch for the purposes of assumed default probability, defaulted assets must be treated at the lower of assumed recovery or market value in overcollateralization tests unless they trade above 80%, and all recoveries on defaulted assets must be treated as principal receipts in the cashflow waterfall.
Three provisions not yet seen on the CDO market but considered very important to future issuance are as follows: One, an asset manager must explain in writing why an asset purchased at a low price is not a credit-risk asset; the threshold cited was below 80% for a new issue and below 60% for a secondary market asset. Two, trading gains must be reinvested in new collateral assets unless overcollateralization ratios have remained at their original levels and all other asset quality tests are being met. Three, all funds raised from the sale of debt and equity tranches must be used to purchase collateral, even if the CDO can meet its target portfolio without investing such proceeds.
Not surprisingly, S&P warned that going forward, if all of its new provisions are not enacted, the agency would hold CDOs to harsher default scenarios for the same rating notch desired.
Square peg/round hole?
A large contingent of conference attendees were concerned with over-generalizing the market, stressing that one size does not fit all when it comes to restructuring standards. After all, what benefits a debt tranche holder in a CDO could impact an equity holder in the same vehicle more harshly.
Currently, the short story behind balancing CDO interests, as discussed, has boiled down to this: Equity holders desire that funds withheld from them be applied to the purchase of additional collateral assets, whereas debt tranche holders prefer those same funds to be applied to the principal payment of debt tranches.
"Structural enhancements are a deterrent to the arguably contrived trading patterns of some collateral managers," said David Tesher, head of S&P's fixed income CDO group, "which is often driven by their desire to circumvent delivering by paying down liabilities."
It was widely held by the rating agency that if a CDO's asset deterioration is mild, the CDO should be allowed to reinvest the excess spread in additional collateral, or pay down the junior-most debt tranche. Senior-most debt tranches should be repaid only if the asset deterioration is severe.
The conference also addressed the fact that, according to S&P, mechanisms of a CDO tie the interests of an asset manager more closely to that of debt tranche holders - e.g., incentive fee arrangements and ownership by an asset manager of various debt tranches. S&P proposed an asset manager's purchase of both equity and junior-most debt as an effective solution.
"We're hoping these new ways of approaching CDOs are helpful to both parties," said Douglas Lucas, director of CDO research at UBS Warburg.
As for the equity holders' concerns about new CDO structural protections, Lucas stated he would remind them that, "a CDO s a perfect vehicle to obtain leverage to CDO assets," nothing that the financing term and rate is set for life in a CDO as compared to, say, repo financing.
Lucas noted in a recent UBS research report that CDO market participants should review the different structural credit enhancements being discussed, and incorporated. He was particularly keen on credit enhancement using asset price and spread."We think that market-based measures have the potential to change the focus of CDO credit enhancement to preventative rather than remedial measures," he said.