Following is a Q&A with Bank of America Securities CDO Researcher Lang Gibson, who authors a weekly research report titled Structured Credit Strategy Weekly. Gibson was one of the first bank researchers to specifically incorporate derivatives coverage into a weekly CDO strategy piece.
QWas synthetic CDO volume up in 2002 versus 2001? If so, why?
AIn 2002, $269.3 billion in CDOs was visibly issued globally versus $197.9 billion for 2001 not bad considering corporate credit was in a bear market period. Although global cash CDO volume was off 22%, synthetic volume was ahead 74%. Despite funding across the capital structure becoming increasingly expensive over the year, the synthetic structure has clearly proven to be the most efficient vehicle for repackaging credit.
Synthetic CDO issuance posted its largest growth ever, with $208.7 billion closed visibly in 2002, exceeding 2001's $120.1 billion in visible volume by an astounding 74%. The largest growth occurred in synthetic static deals, which grew by 119% to $105.7 billion and accounted for 50.7% of global synthetic volume in 2002 (versus 40.2% in 2001). Among static arbitrage deals, we saw $71.6 billion referencing investment grade credits and $34.1 billion referencing structured product. The major driver of this 119% volume growth was the exceptionally high funding gap in IG corporate CDOs that we saw after June 2002 particularly in comparison to competing CDO sub-sectors. Although the global synthetic share of synthetic balance sheet deals fell from 50.2% to 38.5% over this period, managed synthetic volume took up some of the slack by doubling to $22.7 billion, accounting for 10.9% in 2002 versus 9.6% in 2001. The substantial majority of 2002 independently managed synthetic volume, or 92%, referenced investment grade credits.
QWhat is the most significant challenge that synthetic CDOs faced in 2002?
AOther than an unprecedented string of investment grade corporate defaults and downward rating migration, the taint of synthetic downgrades over 2002 was the biggest challenge to the market last year. Moody's publicly downgraded 137 tranches in the IG synthetic arbitrage market in 2002 versus only 32 in 2001 (treating pari passu and multiple actions as one count) a growth rate of 328% due primarily to a combination of collateral deterioration, excessive leverage and rating arbitrage in pre-2002 deals. Only with the benefit of hindsight could the market realize that the average 2% equity deposit required for synthetics was insufficient. The thinking was that the higher BBB+ rating in a typical synthetic collateral pool (vs. BBB flat in cash), diversification into EU credits, absence of both interest rate hedge ineffectiveness risk and par accretion risk and short tenor warranted an equity deposit about half the size of that required in a cash deal. This thinking was correct except for the simultaneous occurrence of significant rating arbitrage prevalent in the initial portfolio and unprecedented investment grade defaults. Both investors and issuers effectively took a bet that the extra spread pickup available in various credits vis--vis the market average for a given rating notch was money good. Of course, the spread pickup turned out not to be free money in many cases, and many of these credits (Enron and WorldCom being just a few) rapidly became fallen angels or even defaulted.
QWill this continue in 2003?
ADue to the rapid growth of synthetics (74% year-over-year growth in 2002 alone) in the midst of a lingering recessionary period for corporate credit, the synthetic market will likely continue to suffer from the taint of downgrades, the brunt of which will be borne by pre-2002 deals, which were twice as leveraged on average as more recent deals. With half as much leverage, on average, and other structural protections (e.g., higher attachment points across the capital structure, more diversity, waterfalls and cash trapping, rule-based features, trading restrictions and coupon step-ups) the 2002/03 deals should be better positioned, particularly as the economy improves. Furthermore, in addition to being more wary of rating arbitrage, investors and issuers will increasingly utilize equity-based Merton credit portfolio models to maximize risk-adjusted return in the initial (and in some case ongoing) portfolio for a given structure. Lastly, independently managed synthetics will likely never suffer from a downgrade taint, as these deals were structured with more protections overall in the first place. In the history of this market, there have been only two tranches from one deal downgraded.
QIs it a myth that placing the super senior tranche is easy, and if so, why?
AYes. The latter half of 2002 proved that it can be just as difficult to place super senior positions as it has been to sell triple-A notes in cash deals in the past. However, in 2002, cash deals were also increasingly hard to sell across the entire capital structure, triple-As included (e.g., the 22% drop-off in global cash issuance). Arguably the most substantial impediment to selling super senior swaps in 2002 was the fact that there were far fewer active senior protection sellers (e.g., the monolines, many reinsurers and some insurers) in the CDO space over 2002. The decreased activity largely represented a protest against restructuring in credit default swap (CDS) contracts. Anecdotal evidence suggests that a few senior protection sellers have been successful in taking out restructuring altogether in the deals' credit event language, mostly in private deals. Furthermore, in addition to restructuring concerns, many senior protection sellers decreased their activity to digest mark-to-market losses on their super senior swaps, whose subordination deteriorated in concert with the proliferation of IG synthetic downgrades over 2002.
QHas the cost of placing the super senior tranche increased and if so, by how much compared to 2001?
AYes. Senior protection sellers have achieved better pricing through a combination of larger premiums and/or higher attachment points. Super senior premiums have generally moved higher from about 7 to 10 basis points to about 12 to 15 basis points, on average, depending on the concession on subordination. Additionally, attachment points (e.g., subordination) have risen from 8% to 12% over 2002, on average, for junior super seniors (according to BAS data) and from 10% to the 17% to 21% range for the most senior swap (according to Standard & Poor's, which has access to private super senior data). To explain, there were generally two super senior swaps contained in deals issued over the past year. For example, at the top of the capital structure, a super senior structured at a 20% attachment point implies that 20% of the capital structure is subordinate to the super senior swap in the form of a "junior super senior" swap and funded notes and equity below that. We note that junior super senior swaps imply higher super senior attachment points and make the junior swap look like richly priced triple-As. With this "sub-tranching" of super senior swaps, senior protection sellers are able to improve their profitability ratios, as many companies have minimum limits on the ratio of income to notional exposure. Furthermore, by structuring a junior super senior swap into the deal, it is easier to sell the super senior swap, which has more subordination by extension.