One of several innovations that analysts from Standard & Poor's will be highlighting at a press briefing Tuesday will be the first CDO-cubed transaction Europe is expected to see in the near term.

Perry Inglis and Simon Collingridge, managing directors in structured finance at S&P in London, said tightening credit spreads forced many changes in the CDO market this year, from new structures to a dramatically different deal mix.

Although Inglis and Collingridge could not disclose details about the CDO-cubed transaction last week, they said more information will be made public at their upcoming presentation, which provides an overview of the European CDO market, including the latest trends and their outlook for the fourth quarter. They offered a brief preview of their analysis in an interview last week.

Inglis said synthetic transactions continue to dominate issuance. Of the 274 public and private deals that S&P rated so far this year, only 25 are cash deals, with the collateral for the majority of those being either leveraged loans or ABS.

Inglis also said a major shift in CDO structures emerged over the past six to nine months. For example, the number of CDO-squared transactions grew significantly. S&P rated 97 of those so far this year, which is more than triple the 32 CDO-squared deals that came in all of 2003.

At the same time, S&P registered a marked decrease in the number of vanilla, single-tranche CDOs - 133 so far this year. Inglis said there were a total of 259 of those deals in 2003. However, he added, the average size grew significantly in 2004, so total volume is up, despite fewer deals.

Tightening credit spreads are driving the changes in the deal mix, as well as structural innovations, according to the S&P analysts.

Inglis said iTraxx, an index of single-name corporate credit default swaps that are often referenced in synthetic CDO deals, tightened by eight basis points over the past six weeks. "Bearing in mind that it was only at 40 basis points to start off with, that's significant tightening," he said. "It makes a big difference to the economics of these transactions and their attractiveness to investors."

Consequently, CDO arrangers are working on even more structural changes to further leverage the thinning arbitrage on corporate portfolios. The latest development is the CDO-cubed transaction. Inglis said S&P just rated the first one, and although he could not reveal the issuer or size, he expects more details to be released this week.

"There's a lot of innovation in the market because of this very tight credit spread environment," Inglis said. "The credit speads on the underlying assets just don't allow any more the straight-forward structure that we've seen previously, whether it's in the cash market or the synthetic market."

Among the trends in cash CDOs, Inglis noted the increasing use of money market tranches, where a part of the triple-A piece will be given a shorter maturity than the underlying assets. "That can be purchased by different investors at a much tighter spread to compensate for tightening on the underlying assets," he said. There is also increasing use of market-value structures.

Fourth quarter outlook

S&P anticipates CDO volume will continue to be strong in the fourth quarter. And although synthetics should remain dominant, more than 40 cash transactions are in the pipeline, all hoping to close before the end of the year.

That pending glut is driven mostly by SME transactions from continental Europe, with Germany, Italy and Spain leading the charge.

The mix also includes CDOs of ABS and leveraged loans. The ABS collateral is mostly mezzanine, an ongoing trend driven by the search for yield.

Given the pipeline, the total number of cash deals is likely to be more than 50 by year end - which Inglis said represents "significant growth" in volume. "Actually, that's higher growth than the synthetic market," he said.

The final count for 2004 could be as much as double the 32 cash deals completed in 2003, Collingridge added.

It is unclear what might be the impetus behind so many cash deals coming in the final quarter. However, many CDOs are balance-sheet driven, Inglis said, "so there may be a true year-end aspect to that."

A maturing European market might be another contributing factor. "In Europe, some of the markets, in terms of overall securitization, are just beginning to take off.

Spain for example, where there has yet to be much securitization of any description in the past, but now there's been quite a few RMBS transactions over the past year," Inglis said, adding that, after mortgages, the next most obvious asset class for banks to securitize are loans for small- to medium-sized businesses, prompting more SME CLOs. In addition, increasing ABS issuance provides more collateral for CDOs of ABS.

Better performance

and monitoring

Another development is that seasoning is leading to better performance for CDOs in general. In the third quarter, S&P downgraded three transactions with a total of four classes and upgraded three transactions with a total of seven classes, which Collingridge said represents a reduction in the number of downgrades.

A recovery in the corporate market is another contributing factor to the improving performance. "There's a combination of a more benign environment in corporate ratings, as well as more seasoning of the CDOs," Collingridge said. "Maturity is a key driver in the ratings. As these deals get older, I would anticipate that you will start seeing more upgrades. It's quite positive from that standpoint."

Because so much of the market is synthetic, there has been a lot of concern about execution risk - or, the difference between the arbitrage that might prompt a would-be issuer to arrange a deal versus the outcome when they approach the rating agency. To address that issue, S&P is working with arrangers and investors to be more transparent, Inglis said.

The ongoing challenge lies in the need for arrangers to lock in arbitrage before a deal can be rated, even though the arbitrage is linked to the rating.

As part of its effort to assist those who are creating and monitoring CDOs, S&P is introducing two new tools, CDS Xpress and CDS Accelerator. Express gives clients the ability to access a database of the most liquid corporate entities commonly referenced in the credit derivatives market. Accelerator takes that information and allows market participants to quantify and analyze the risk profile of new and existing synthetic CDOs. "So it basically hooks up that information from CDO Express to our evaluator tools and allows analysis from there," Inglis said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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