The public markets' equity researchers may garner more television appearances, but there's no shortage of commentary swirling from fixed-income CDO think tanks. Equity tranches within CDOs are the new hot topic for the CDO market, as one bank's research group claims some market documentation is more worthy of the trash can than investors' attention.
"The calculation of these variables is so fundamentally flawed that the results are useless," says UBS' Director Douglas Lucas. His research team's piece looks at market guidance issued about monthly volatility of equity returns, their Sharpe ratio and the correlation of CDO equity returns to the returns of other assets. After careful study, UBS concluded the only historic data that provides insight into future CDO equity performance is the default and recovery of underlying CDO assets. Therefore, current guidance out in front of investors is "is extremely misguided," the UBS report said.
While that, in and of itself, may sound like mild subject material, controversy swirled around the new report because at least three other investment firms have released analyses that purport to capture CDO equity-related data. One structured credit group issued a returns and correlations piece in February that was publicly discussed at a recent IMN conference.
"You can't perform a calculation of correlation from just 10 data points," one CDO researcher familiar with the situation said of that February correlation report. The CDO researcher pointed out an obvious flaw: The correlation report did not explain what an investor could expect to get from buying CDO equity totals.
No names are dropped in the UBS piece, and Lucas had no comment on whose research his report referred to. However, he did clarify his piece was penned after UBS received numerous requests to produce its own monthly figures regarding CDO equity returns, because other firms were doing it. Those requests hit a wrong note with Lucas, who argues, among other things, that the process of tracking monthly CDO equity returns is impossible given that the secondary market for CDO equity is underdeveloped.
Lucas believed it was time to set the record straight. The UBS report disputes prevailing wisdom, citing the practice of adjusting for statistical anomalies, excluding extreme values, or linear interpolation as examples of research gone awry. In short, the UBS report contends the struggle to say something about CDO equity market value volatility is impossible given that there are not monthly CDO equity prices nor monthly CDO equity returns.
Insiders at a few firms allude to pressure on CDO researchers, from sales and marketing, to come up with material suitable for the new wave of investors entering the market, such as pension and private wealth clients.
Another researcher at a leading underwriter, not associated with any of these reports, says the hype over CDO equity may generate from a desire to better market the security.
According to the researcher, who did not want to be identified, marketing personnel from with the researcher's own firm were excited over the prospect of utilizing CDO equity-related research and data points to support sales of the CDO equity product to investors. However, the researcher immediately halted any effort to do so.
"Current attempts to capture CDO equity data are goofy analyses that draw stupid conclusions," the source said. "I would never, in my life, support such a thing."
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