A more mature market basking in the benefits of increased transparency. The birth of fluid, secondary trading. Fresh new asset types and improved structures. These were the mantras of IMN's annual New York-based CDO conference last week.
With FIN 46 concerns now off the hot plate, the market homed in on increased diversification among investor types, the continued development of the secondary market, CDO manager fees, decreased spread charges from monolines and finding arbitrage in the wake of spread tightening this year.
Numerous panelists throughout the two-day event observed that hedge funds participated in greater numbers last year; among other effects, this new investor audience helped to drive liquidity in the secondary market. Interest in the CDO market among pension funds, endowments and foundations is sprouting, participants also reported.
On the other hand, some market participants made note of what's missing this year.
"Five years ago there was only one asset class - high yield," noted Christopher Ricciardi, head of global structured credit products at Merrill Lynch, pointing out the current drought of high yield-backed deals.
David Tesher, a managing director at Standard & Poor's, agreed. Maturity has developed in the market without high yield - the initial building block of the CDO market, he noted.
Back in 2000, high yield bonds backed two-thirds of issuance while one-third was backed high yield loans, Tesher said. Yet by 2003 that mix had shifted dramatically - more than half of last year's issuance was in CLOs or structured finance CDOs, "which you didn't even see in 2000," Tesher said. Little to nothing backed by high yield bonds was issued last year. "We're seeing inquiries...it may be a good relative value play, but no, the pipeline is not full [of high yield-backed deals]," he said.
Ricciardi noted CDOs of ABS were clearly the most popular type of cash issuance last year and will continue to be popular this year. Synthetics will continue to rise in popularity, particularly single-tranche CDOs. A product likely to arise this year will be CDOs backed by equity default swaps (see story, p. 1). By contrast, bank-backed TruPS are popular, but it's difficult to get the collateral, he said. And if spreads continue to remain tight, more money market CDOs and pro rata deals, namely those using revolvers, will see increased issuance this year, he predicted.
"It's a very difficult time to ramp up transactions - it's hard to justify where to place equity," said James Damron, senior managing director, PPM America. There are still plenty of CLOs issued in 2003 that haven't fully ramped, he noted.
CDO managers in the spotlight
Gus Harris, managing director at Moody's Investors Service, led a panel charged with delving into "difficult issues," and it packed the house.
Debate ensued over CDO manager fees and whether the current fee structure added turmoil to the corporate governance issue of the misalignment of trading strategies already present in the CDO structure. Typically, current managers are paid a small senior fee upfront but stand to gain a much larger subordinate fee, tied to the deal's waterfall.
Panelist Arturo Cifuentes, a managing director at Wachovia Securities, stated such a setup creates no real incentive for long-term oversight, particularly should the transaction run into trouble as many have; the bulk of their payment is derived out of the waterfall and if that struggles, the CDO manager stands to never get paid. The manager then begins to care much less about the CDO in the long term. Cifuentes suggested paying CDO managers a hefty senior fee upfront, but giving investors much more leeway to fire a manager if the transaction doesn't perform well. Needless to say, the suggestion stirred up quite a bit of debate in the room.
Harris' panel also took up the urban myth that structured finance ratings are better than corporate ratings.
"There is no difference," said Harris, stating a view shared by panel members including Dan Ivascyn, senior vice president, PIMCO; John Mawe, senior vice president, Lehman Brothers; Douglas Lucas, director, UBS Securities; and Jerry Hong, portfolio manager, Zais Group.
As one panel member pointed out, both areas took a beating with ratings downgrades over the last 18 months.
Insurers charging less spread
"We're trying to be realistic as we think about where we want to participate," said FSA's Director Steve Kahn.
Kahn conceded a point discussed around the conference: the surge in single-tranche CDOs (STCDOs) means that there is less super senior product available for insurers to wrap.
That shift hasn't impacted FSA's business, Kahn said, noting his firm is evaluating other areas of the sector, including market value, TruPS and high yield synthetic issuance.
But the advent of STCDOs isn't the only factor affecting monolines this year. Conference sources reported that alongside changes in investor appetite for product and overall spread tightening, the influx of increased competition has led to insurers charging less this year. The market four years ago had MBIA, FGIC, Ambac and FSA; now CIFG and XLCA have entered the triple-A monoline picture.
In fact, one panel's speakers discussed the fact that monolines are charging half as much for guarantees as they did last year. This price drop pertains largely to the cash market CDO deals.
"The primary catalyst for CDO spread tightening is the increasing aggressiveness of reinsurer wrap pricing on first priority triple-A tranches," said Lang Gibson, principal, Banc of America Securities. Reinsurers are charging less because the risk has diminished so much, Gibson said.
No hard figures were made public. However, one source stated that if the spread for wrapping triple-As was at 20 basis points last year, a cut to 10 basis points would seem in line this year.
"There's more competition, better pricing and more information available today," said one rating agency source.
Another source noted purchasing a wrap on a CLO this year was much cheaper, but that a CBO wrap is still expensive, due to the differences in performance.
Rubbing the crystal ball
According to Brad Brown, managing director, Banc of America Securities, activity in 2004 has reached about $8.3 billion, outpacing 2003 by 82%. The search for yield from the buyside, the resolution of accounting issues, increased transparency, secondary market liquidity and structural enhancements are all catalysts for this situation, Brown said.
To shed insight as to where things are moving this year, Tesher presented S&P's forward-looking pipeline of U.S. CDOs: 28%, CBO of ABS; 24%, arbitrage CLO; 14%, correlation trade (single-tranche CDOs); 9%, synthetic CDO; 8%, trust preferred; 7%, real estate CBO; 5%, CDOs of CDOs; 5%, re-tranche.
In 2003, investment-grade issuance was almost at historical levels and speculative-grade issuance "is exceeding all levels from the last 10 years," said Tesher. As downgrades stabilize to more historically normal levels, CDOs have actually remained very resilient and performed admirably compared to corporates, he added.
Going forward, numerous panelists called for a better measure of modeling hedges embedded in CDOs.
"There are people who do a good job at predicting effects...we should come up with better tools to handle the risk of transactions," said Wachovia's Cifuentes, who gave a special presentation entitled Earthquakes, Defaults and CDOs: Managing The Unpredictable. "People claim CDOs cannot be predicted, and that's wrong," he said. Earthquake engineers for decades have moved forward constructing buildings, and even skyscrapers, in known earthquake zones such as California and Japan. Comparing CDO analysis to seismic analysis, Cifuentes explained these engineers gave up trying to predict when an earthquake event would take place. Yet, they nonetheless have modeled correctly for risk factors, a fact accentuated by the buildings still standing in spite of seismic events. "The point is there are tools people have built to measure uncertainty. Effects can be estimated and you need to know what the effects are," Cifuentes said.