At this point it's old news that the CDO market stumbled about in a stupefied-like manner for most of 2002. However, the size and depth of the CDO market is much larger in scope than just the United States. So what's happened to the overseas brethren?
As was the case in the U.S., European investors were scrambling around for a bottle of aspirin. But unlike the U.S., just how bad it was depends on to whom you ask.
Overall, it appears the only good news for both sides of the Atlantic is that a new year has begun.
European collateralized debt obligations saw a steep drop in issuance in 2002 and spreads widened significantly, according to recently released figures from the London office of JPMorgan Securities.
The sector accounted for the bulk of rating and spread underperformance. Juxtaposed against European consumer securitization - such as ABS and MBS - which posted a banner year in terms of issuance and enjoyed dominating rating upgrades, CDOs were quite obviously "de mode."
"CDO funded issuance slumped nearly 40%, given shift from balance sheet to managed, and from cash to synthetic," noted Ganesh Rajendra, head of European securitization research for JPMorgan.
Rajendra's team reported that many traditional ABS investors that had bought CDOs in earlier years effectively withdrew from the market last year, owing to its greater credit volatility.
And new investors reportedly steer clear from the asset class for the same reason.
On the upside, while CDOs accounted for 70% of downgrades, only a few CDOs were responsible for the bulk of downgrade activity, according to Rajendra.
"CDOs investors, particularly toward the second half of the year, became very cautious. CDO became a bad word for investors," said Ken Gill, managing director at Fitch Ratings in London.
"European structured finance volume was not as healthy as was expected. Final cash funded was approximately $134.8 billion," said Gill.
As head of European CDOs within the Fitch's European structured finance division, Gill believed the shunning was not entirely justified. The entire CDO market experienced trouble, whereas problems were centered primarily in the high yield sector, where default rates were much higher than ever before and recover rates were much lower, he said.
A mixed review
Yet painting a different picture is research issued last week from Moody's Investor Service, which states European CDO market experienced another year of "dramatic growth" in 2002.
"The total market volume of credit risk transferred reached $183 billion (EUR182 billion) in 2002 - a 42% growth in volume over 2001," said Katherine Frey, Moody's vice president/senior credit officer.
The one thing all sources agreed on was the dramatic rise in synthetic CDOs, the largest sector for growth in 2002.
"That defiantly was the major growth sector in 2002, just in terms in the number of deals that we rated," said Gill. "There's less investor appetite in the traditional cash buyers for CDO products. So to sell the risk in a non-cash way is an effective alternative for protection buyers."
Moody's saw a 45% increase in the number of rated synthetic deals compared to cash deals last year and approximately 96% of deal volume and 85% of the number of deals were synthetics.
CDOs spell middle-market loan relief
Interestingly, more balance sheet deals are seen in Europe than in the U.S., and particularly favored by German and Spanish banks. These products are analogous to middle market loans in the U.S., Gill explained, and are a staple of the CDO market in Europe because of their stability.
Additionally, Fitch estimates that approximately $5.6 billion was issued in cash-funded high yield arbitrage, and the credit agency rated half of that. The volume was similar to that seen in 2001.
What did sprout last year was a taste by European investors for new CDO innovations, dubbed alternative investment CDOs. Most notable was increasing demand for hedge funds and private equity-derived CDOs. According to Gill, Fitch is spending more R&D on these alternative investments.
"It's not a good time for some of the hedge funds and private equity funds in terms of returns," he said, "but we as a credit agency can quantify the risk associated with it in a down time just as good as in a good time."
One such CDO issued last year was of undated European bank sub-debt and the first collateralized fund obligation, noted Moody's Frey. "Additionally, almost half of the cash deals were resecuritizations, reflecting a move towards higher-quality stable assets," she said.
JPMorgan's team found that European investors liked the benefits of diversity afforded to a typical CDO asset pool from non-benchmark jurisdictions in securitized products.
"Over 2002, hedge fund-like vehicles also increased in number, investing in ABS with leverage gained from borrowed capital (i.e. the repo market)," Rajendra's report stated.
All in all, it appears newer CDO issuance stands a much better chance at surviving the ride in the European market place in 2003.
"For CDOs, we expect the more recent vintages to outperform their predecessors. On a fundamental basis at least, spreads should have a tightening bias through 2003," said Rajendra.