White Sulphur Springs, W. Va.-A surprise mention of the collateralized debt obligation sector by Federal Reserve Chairman Alan Greenspan could spur more interest in the already burgeoning market, as well as inspire underwriters to create an elite class of top-rated CDOs as a possible benchmark alternative to Treasury bonds.
Greenspan, speaking via satellite at the end of April to the Bond Market Association's annual convention at the Greenbrier Hotel here, spoke on the pressing need to find bond market pricing alternatives to the dwindling Treasury market. He mentioned swaps, Ginnie Maes (see story below) and, most intriguingly, a high-grade CDO as worthy candidates of the Treasury market's replacement.
"Given sufficient demand, you could produce a nearly riskless security," he said. "A senior tranche of a CDO backed by high-grade corporate debt, for example." Conference attendees said they were surprised and pleased at Greenspan's specificity, and considered it good news for the already healthy CDO market.
Back on Wall Street, as news of Greenspan's comments spread through the structured finance universe last week, a number of longtime market players expressed astonishment that Greenspan had deigned to mention the market. After all, while CDOs have been growing in popularity, they still occupy an obscure corner of the asset-backed securities market in the eyes of the general public. Many said they had never heard Greenspan, let alone any major political figure, mention CDOs before, and said it gave the market a new sense of establishment.
"All it can do is help," said Robert Grossman, group managing director of loan products for Fitch Inc. " This market has grown from relative obscurity to become a large part of the current asset-backed market. Now even more people know about it."
CDO players agreed that what Greenspan proposed - a sort of elite class of high-grade CDOs - could easily be assembled by any major issuer.
"Senior tranches of CDOs are considered a safe haven [by some investors] because they incorporate less event risk than similarly rated corporate bonds," said Blythe Masters, a managing director at J.P. Morgan Chase who runs the company's American structured credit products operations.
Yet would such bonds be benchmark potential? Many pros agree that the market has a long way to go before it can compete with the bonds that have already been considered as Treasury alternatives, such as dollar swaps, agency debt and a handful of top-rated corporate bonds. A key problem for CDOs is that pricing transparency is not that great-indeed, only recently have data concerns like Thomson Financial even attempted to do quarterly league tables for the market, and determining secondary pricing is still spotty.
Masters and other CDO officials said that the high-grade CDO market still requires much more regular issuance and greater liquidity before it has the possibility of becoming a benchmark. "The swaps market is the only viable alternative as a benchmark to Treasurys now," Masters said.
Sunset for Treasurys
Greenspan's statements at the BMA meeting echoed a growing belief that the Treasury market, especially long-term bonds, could fade into oblivion in the next few years if the federal government continues to produce budget surpluses. There is also some apprehension about the vacuum that would leave in the debt markets.
"The Treasury market has a number of useful purposes other than providing many of you with profitable employment," Greenspan joked to the audience of bankers and bond issuers. "I recognize the [Treasury] paydown could have some potential adverse consequences," he added, including for the Fed itself, as the Reserve now purchases large amounts of Treasurys for its own portfolio.
As the market for Treasurys dwindles, however, any major Fed purchases would have a growing financial impact, and could begin to significantly affect pricing of the bonds in secondary markets. In the past, the Treasury market was so vast that even multi-billion dollar Fed purchases were absorbed without a ripple.
Some possibilities for the Fed include purchasing Ginnie Mae mortgage-backed securities, which are guaranteed by the federal government and have been compared to Treasury bonds with less liquidity. Greenspan also mentioned municipal bonds or foreign government debt.
Another possible problem: Foreign investors, which currently are among the largest holders of Treasury bonds, could reduce their overall holdings of dollar-based securities if the Treasury market dwindles. Greenspan said he did not think this would be a likely scenario, especially if other dollar-based securities like agency bonds or swaps step in to fill Treasury bonds' benchmark role.
As for the economy, Greenspan and other speakers agreed that while there may be a few recessionary quarters, the fundamental health of the economy would remain sound for the next few years. "The dramatic improvement reflects a pickup in the underlying productivity growth in the U.S. economy...that will likely be sustained throughout the next decade," Greenspan said.
Also speaking at the conference was Sen. Jon Corzine (D-N.J.), who highlighted a number of upcoming congressional battles that could affect the bond markets. Many attending the conference said they especially fear the possible further Congressional investigation of Freddie Mac and Fannie Mae for purported violations of their charters. Corzine said to expect some battles: "There will be a lot of hooting and hollering about [the agencies] and their roles," he told the conference.
