PONTE VEDRA, Fla. - For four days last week, 300 CDO professionals took a bet on a relatively unknown conference company, Opal Financial, and descended upon this suburb of Jacksonville, Fla. for the firm's inaugural CDO Summit.
Opal combined the CDO Summit with it fourth annual Alternative Investing Summit, which is targeted toward hedge funds, increasing the total number of participants to 650, organizers said. And with the exception of some patches of rain, a basement resembling a hockey-rink locker room for booths, and mediocre hotel food, most attendees were not disappointed.
Content on the panels was generally solid, largely due to the moderator in many cases choosing his or her own panelists. Nevertheless, some overzealous salesmen didn't miss the opportunity to market their firm's expertise on the pulpit. One boastful salesman even mentioned at least three times in one panel that his bank's CDO product offers great value' - quoting a very attractive percent.
CDO celebrity Drew Dickey of Mass Mutual /David L. Babson opened the event, establishing the conference theme of CDOs at a crossroads amid challenging times, new accounting rules, downgrades, and a shaky economy.
Barclay's Bank's new Global Head of CDOs, Eileen Murphy, moderated the first panel, entitled "What have we learned from the past?", which included a few "sour grapes" comments regarding the product's less-than-glorious history, presented by a pension investor.
The investor's recount of what was learned from having two out of the company's four CDOs downgraded was a bit sobering. For instance, one position in the new investor's portfolio is supported by a pool with 30% defaulted securities.
And perhaps exemplifying the lethargic attitude with which certain underwriters take care of amendments on a problem CDO, the investor related that despite the fact that the 1998 high-yield CDO in question had been downgraded to triple-C from double-B-plus, a notice to vote to replace the collateral manager or amend the documentation (66 2/3 majority required) had yet to be sent out - even though the double-B-plus tranche was downgraded to triple-C in July 2001.
The investor speculated that the underwriter was of the opinion that taking care of amendments on a problem CDO which is already closed is a non-revenue-generating proposition, and it is more advantageous to take the pension manager off the client rather than cope with each investor's gripes continually; i.e. many unreturned phone calls.
What are the lessons learned for this first-time investor?: Read the offering circular and use legal counsel for anything you don't understand; read the pitch book with caution, especially the scenario analysis; and if the dealer says this is a great time to buy because market is down, remember it may go down further, as it did in this vintage.
Daniel Smith, a managing director at Royal Bank of Canada, added that it seems ironic that CDOs, which are quasi-finance companies, can perform horribly and yet the manager still often receives its fees. For Smith, one lesson learned from the past is that it makes sense to have a portion of the management fees dependent upon the performance of the deal.
Other points added on several panels were that managing a portfolio and managing a CDO - with all of its constraints - are two different animals, and it often takes new issuers more than one deal to figure this out. "If everything is going fine the structure and documentation don't matter so much; it is when there are problems that the documentation constraints become an issue," said one participant.
Additional overcollateralization tests above the junior tranche are also a step forward, as they allow for the diversion of excess interest to purchase collateral in order to re-build the par value of the CDO. Another possibility would be having delayed draws in transactions, allowing for an extended ramp-up at the most opportune time, said Stuart Rothenberg, an associate at Standard & Poor's.
One issue that panelists were almost uniformly against are forced sales of securities within one year of default, which in some circumstances is done at five to thirty cents on the dollar. "CDO indentures should have provisions providing more flexibility to fully realize the value of work-out and seeing a company through its Chapter 11 process," said one participant, adding that selling bonds at the wrong time can kill a transaction.
A core competency?
The idea of CDOs being a core competency was raised by Dickey, adding that one CDO portfolio manager recently told him that 40% of his time is spent keeping two CDOs in compliance with the deal documentation. With that kind of time commitment required to maintain compliance with the deal's documentation, problems will undoubtedly arise if CDOs are not a core product, he added.
Driving home the theme of manager, manager, manager', one panelist said that there are two main issues with bad CDO sponsors: turnover of personnel (often addressed in key-man' covenants) and whether the product is a strategic part of a portfolio manager's continuous business. "Due diligence is not about who has the thickest files and neatest desk; you have to look at their past CDOs in detail and whether the team is going to stick together," noted one panelist. "These deals last longer than many marriages."
According to another panelist, there are three rules of thumb for investing in CDOs: no static pools; find the right manager and make sure they have the power (in the indenture) to do their job; and make sure that the manager understands the structure. The presenter added that managers should keep things simple and try and use the same definitions in each deal.
One of the best panels at the conference was on the CDO secondary market, moderated by Hartford Investment Management Co.'s John Prestley.
One comment made on the panel is that extreme bargains exist in the secondary market that push some sophisticated investors away from the primary market. The panel largely agreed that compared to other private structured products such as CMOs, the CDO secondary market is extremely primitive in terms of finding current and accurate data on systems like Intex Solutions, Inc.
One barrier to finding updated data is that many CDO indentures restrict the sharing of trustee reports to investors in the deal, rating agencies, and the dealer, but not to data providers like Intex. However, this may be changing: Mass Mutual now puts instructions in every CDO indenture from its shop that data should be sent to vendors like Intex in order to provide more transparency and encourage trading.
Said one participant: "I suggest that a secondary market investor checks whether any data posted on a third party system is up to date and correct - by calling the respective underwriter."