It appears CDO investors have moved in larger numbers toward a newer method for analyzing collateral - at least for high yield and leverage loan CDOs.
While investment banks have been doing it a bit differently for some time now, investors have still clung to ratings-based CDR (constant default rate) cash flow methodology. However, comments at a recent CDO-focused conference in New York revealed that a transition toward pricing using individual asset prices and individual default rate is occurring.
"Coming out of the conference," noted one investor, "I got the sense that a shift is underway."
The investment banks aren't categorizing the shift as fundamental, but that may be because they have been privy to the newer scenarios earlier than the average CDO investor.
"It's the $64 million question - how do you come up with your default estimates on your CDO portfolio. I'd call this a qualitative difference not a quantitative difference. It's not like we were riding horses and now we're in cars, it's just a different horse," said one CDO researcher.
"I don't know of a fundamental shift. I would say it would be investor-specific," said an investment banker. "The more sophisticated ones might do that."
At the core of it all is indeed the $64 million question. Currently, the cash flow constant default rate method involves the same default rate for every asset in the whole portfolio. The more individualized application is just as the name suggests - asset prices of each individual asset in the CDO are taken into account.
For example, with a high yield bond CDO, the model would take the prices of each individual bond in the CDO and from that derive a default rate. By taking individual prices, the methodology grabs the most current and up-to-date price of the high yield bond, supporters of the method tout. And that hits the underlying fundamental issue - pricing.
With the CDR method, bonds are valued in one of two ways: at par or default. In between those terms is an enormous gray area; one high yield bond scenario would show bonds that are not trading at par but have not defaulted, and are trading at 90 cents, 50 cents, even 20 cents on the dollar. If a company backing the bond is doing well, it may be trading in the 90-cent range, but if it's doing badly the market could reflect that by a 20-cent range. If one were using the CDR method, the 20 cent bond, which hadn't defaulted, would be carried at par. Taking into account specific prices, rather than the "at par" or "at default" categories creates a much more accurate and timely picture of every bond in that portfolio, supporters say.
"You can have a whole portfolio of high yield bonds and leverage loan CDOs and most of the bonds are credit-impaired - trading at 30 cents, 70 cents on the dollar - yet they're being carried at par so that is not an accurate representation of what's going on," said an investor.
To be fair, up-to-the-minute pricing information was not readily available even five years ago. The advent of pricing sources, such as LoanX, to name one, has added a level of transparency to the market never seen before, and high yield bond and leverage loans have now become so liquid that pricing is readily available. (But sources caution that hasn't exactly translated to faster execution of CDOs, which are still taking the better part of a week or two for investors to take apart.)
"From what I can tell, most people have moved toward this asset-priced model and have essentially discarded the ratings-based cash flow model," said a market source. "There's much more active pricing and everyone else in the community is moving toward the same platform," a source said.
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