With profit taking trades underway in current trading activity, it appears the secondary CDO market has developed into more than a place to shop around a bid list. And in the words of many CDO researchers, 2004 will go down as the year this market maturity but the quest for reliable spread information is just one of the many challenges the secondary market faces as it enters the New Year.
"2004 showed that trading activity in the secondary market was not a one-year phenomenon based on the liquidation of the Abbey National portfolio," said Adam Siegel, managing director, Bear Stearns. "Last year at this time, we were sitting with investors discussing the liquidation of the Abbey National portfolio and people wondered, was this it?'"
The majority of trading in 2003 was focused on first priority senior cash flows, according to Siegel. "In 2004, only 55% of our trading activity was in the triple-A space. The remainder ranged from double-As to equity. This is quite impressive," he said.
While the year showed dramatic growth in secondary trading, market participants believe there is still a long way to go before secondary CDO trading is considered matured.
"In a market that's totally matured and efficient, everyone's going to be doing the work in a very similar fashion, and often coming to very similar conclusions," said Steven D. Finnk, at United Capital Markets. "I think this was a year where the secondary CDO market has matured a great deal...but I wouldn't say it is totally mature."
But wrapping up the year at fantastically tight spreads alongside a deluge of new investors puts the secondary CDO market on more cautionary footing for 2005. Too much competition in sectors not easily understood by new investors could prove taxing.
For example, CDO bids in the secondary market still vary widely from one another and it is more than not common to have outlier bids.
"Other than discussion between market players, it's hard to get any kind of transparency. You can't rely on what you read in most dealer research because it's typically not exactly true of what's going on out there," said one hedge fund investor who has been active in the CDO market for several years.
The challenge to properly price secondary CDO trades has been particularly daunting in structured finance CDOs, particularly mezzanine pieces of ABS CDOs.
"Getting prices on ABS is very difficult, especially the distressed ABS paper," said Johnny Srivastava, vice president, Fieldstone Capital. "Paper across the capital structure now trades but the secondary CDO market has a long way to go before it is as liquid as, say, the secondary market for ABS," he said.
"As you go from CLOs to ABS CDOs, you're entering a more complicated collateral sector and a less transparent pricing space," added Bear's Siegel. "If you were to look at the sub-prime housing market, people have very different views on the health and long-term strength of the U.S. housing market," so quotes on ABS CDOs with leveraged exposure to sub-prime bonds will vary, based on opinions, Siegel explained.
That said, trading is dramatically different than it was just 18 months ago, said Fieldstone's Srivastava. "Trades [for CDOs] take days or hours instead of weeks," he said.
Transparency efforts aided the secondary market in 2004. The Bond Market Association launched a CDO library, a central location where qualified institutions can access CDO deal documentation and trustee reports. Its long-term effect upon transparency in the secondary market remain to be seen.
"For the most part, if it's a dealer showing you a bond, they know you're going to want to see the deal docs," said a vice president at a hedge fund active in the secondary market. "You could probably get by without using the CDO library, although I think it's a good thing."
Of course, like bids, not everyone agrees. "Everyone is on Intex or Wall Street Analytics," said one secondary CDO trader. "It's not useful," he said of the CDO library.
"Ultimately, it will be extremely useful," predicted UCM's Finnk. As bankers are putting new issue deal documents into the BMA's library, five years down the line it could make a huge difference, he said.
"Transparency has improved tremedously during the year, in terms of analytics and pricing underlying assets being available," said David Weeks, director in CDO trading, Merrill Lynch. His firm has been active with the creation of the BMA's CDO library and is the only dealer to make 100% of the deals that it underwrites available to the CDO library, Weeks claimed.
Along with the BMA, "we are working with trustees and rating agencies and other investment banks to provide standardized data fields for reporting on deals," Weeks said. "If you have standardized data fields, systems and analytics can be built around those standard fields, allowing for comparison of one deal against a lot easier," Weeks explained.
The Latest Craze: SF CDOs
Structured finance CDOs can contain anywhere from 80 to 120, or more individual bonds, each with its own unique characteristics. Varying independent assessments of these line items combined with variations in structural analysis contribute to current market inefficiencies, and may drive the bid/ask spread all over the map.
"In the corporate bond market, things trade within ticks, and the bid/ask spread falls within ticks. We're not really there yet in CDOs," explained Finnk. "You still have outliers. In some way shape or form, the homework isn't being done the same way at everyone's desk."
Opinions varied as to if a third party data provider could enter the secondary CDO market and have an impact. Several sources noted that CDOs are essentially private placements, and in deals like ABS CDOs, the underlying collateral has no paper trail from the rating agencies.
Others are more optimistic that a pricing service could one day be made available.
"I could see that happening, along the lines of other ABS markets," said Merrill's Weeks. "What's unique about CDOs is that you actually have the ability to get daily pricing on any other underlying assets for any corporate-backed credit based CDO," Weeks said. He explained this is quite different from some of the other structured finance sectors that don't have underlying markets in the assets that support those deals.
What's Hot, What's Not
Trading has been particularly heavy in a few collateral types this year, including high yield CBOs from the late 1990s, investment grade CDOs and, most recently, multi sector ABS CDOs from 2000 to 2002, according to several active secondary market participants.
"We have seen formerly distressed mezzanine and equity pieces trade up many points within the secondary market due to dramatic improvements in liquidity, credit or capital structure de-levering. Within the ABS CDO sector, secondary spreads have tightened considerably on cleaner deals that resemble new issue collateral pools," said Bear's Siegel. "I see spreads staying tight in the near future. Customers and the Street are very bullish on credit right now. You're really going to need an overall market dislocation or volatility in one of the underlying collateral markets before spreads would widen. "
"CDOs have been such a driving force in all the underlying collateral markets, and volume is up dramatically this year. In an environment where spreads are tight, CDOs are still offering a relatively attractive spread for the rating. Investors of all types are attracted to this asset class," noted Weeks.
Sources agree that while spreads are tight all over, the real concern lies within investors' assessments of ABS-backed CDOs, and their tolerance for holding such sub-pieces.
"Many early vintage mezzanine-ABS backed CDOs have seen solid collateral blowups," said UCM's Finnk of the aircraft lease, manufactured housing and franchise-backed ABS sectors of collateral. "So you have some real dicey mezzanine pieces in these CDOs that have some cuspy prices. People have to be really careful and analyze them all the way through, paying detailed attention to each individual item of collateral" added Finnk.
Other areas on Finnk's watch list are the more subordinate pieces of some resi-related CDO issues. "There is an element of concern in a rising interest rate environment, and the effects that may take shape in the CDO's structure. If prepays change and interest rates change, how does that effect the collateral in the deal, its value, and the value of each tranche within the CDO?" he asked.
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