With the majority of investors believing the CDO market has passed the peak of defaults for 2002, bets are circulating as to which transactions will pass muster and close by year-end. The result has been a mix of reviews and forecasts from analysts as to which collateral type will pan out as the better stocking stuffer.

The CDO market has witnessed more than 50 so-called "fallen angels" this year. However, the recent Federal Reserve rate cut is expected to let the air out of the default balloon. Recent investor memory is one driver of current volatility, particularly at the mezzanine level, sources say. For those cashing in on the volatililty, the mezzanine level presents an impressive opportunity.

Recent activity has pushed up mezzanine prices to Libor plus 10 to 11 basis points at the AA-'/A+' level. Analysts at Banc One Capital Markets called the level of recent volatililty "remarkable" and noted the various tranches of investment grade (IG) synthetic CDOs at the mezzanine levels have shown "eye-popping" yields.

"The credit risk assessment with mezzanines is less than implied by the spreads available," said R. Russell Hurst, director of CDO research at Banc One. If an investor is interested in buying volatility, now is the time to invest in the mezzanine layer of synthetic IG CDOs, Hurst noted.

In addition to the belief that the default peak has effectively cycled through, Hurst and his team have taken into account risk derived from accounting improprieties. Despite the Securities & Exchange Commission's boggling in establishing an accounting oversight board, the agency has nonetheless flexed its regulatory muscle with corporate America. Therefore, Hurst believes an opportunity looms for corporate fundamentalists to take advantage of correlation traders, "by taking a view that the implied probability of default for any corporate name is overstated," he notes.

New issue IG corporate CDO spreads have risen on average for triple-As to 75 to 100 over Libor from 55 to 60 over Libor throughout the past few months, according to Banc of America Securities. During the same time frame, triple-B spreads have widened to Libor plus 400 basis points from Libor plus 300 basis points.

BofA has estimated the premium for taking synthetic triple-A CDO risk over cash is in the 30 to 40 basis points range.

In last week's CDO market commentary, BofA analyst Lang Gibson stated a cash deal is expected to see triple-As between Libor plus 60 and Libor plus 70 as compared to synthetic triple-As which would print at Libor plus 100. Gibson chalks up the premium to the placement of synthetics as the first loss below the super-senior tranche. Cash triple-As do not possess this tranche and represent the last loss position in a CDO. Thus, the analyst states, "the recovery rate would be substantially smaller in the synthetic tranche as compared to the cash bond," assuming an equivalent principal loss.

Under the premium pressure, just one synthetic CDO priced, Broad Street Finance, which was managed by KBC Financial Products and arranged by HSBC. Four cash CDOs priced last week, including a $250 million high yield CLO Venture II CDO Ltd., launched by Barclay Capital Asset Management via Credit Suisse First Boston. According to BofA, the Aaa'/'AAA' senior notes priced at Libor plus 52 basis points; A3'/'A-' notes priced at Libor plus 165 basis points; and the triple-B tranches priced at Libor plus 300 basis points.

Private Equity CDO

Touted Internationally

In other market news Deutsche Banc Capital Partners is out to international investors with a $690 million private equity linked CDO, sources said. Currently on the road in Australia, Switzerland and the Scandinavia region, the vehicle carries five tranches.

Tranche A of the DB Capital deal is a $172.5 million triple-A class talked at 75 basis points over with a 5.4-year average life; tranche B is $117.3 million double-A class at 150 basis points over with a 7.5-average life; tranche C is $62.1 million single-A class at 300 basis points over with a 8.9-year average life; tranche D is $62.1 million triple-B class at 450 to 500 basis points over with a 9.7-year average life; and tranche E is $276 million of unrated notes being retained by the issuer.

According to sources, the deal is a portfolio of 75 private equity funds. All tranches are being offered in fixed or floating rate form in all major currencies. The road show is expected to continue in Spain and Italy this week.

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