Rebellion: *: an act or a show of defiance toward an authority or established convention:
Source: American Heritage Dictionary
Thomas Jefferson once said "a little rebellion now and then is a good thing." He should have been a CDO investor, because right now investors who buy and sell CDOs need to re-examine the flow of information between dealers and themselves. Last year was very trying, indeed, for investors and managers of CDOs. Headlines screamed of multiple credit downgrades, defaults in high yield CDOs and the tumultuously adverse circumstances for managers of ABS CDOs holding distressed franchise loans, manufactured-housing paper, impaired credit card deals and the like. However, the single greatest challenge facing the fixed income investor community will be the steady and perpetual deterioration in asset quality of CDOs as investments.
Unlike traditional public ABS, CDOs are usually private placements that are underwritten and placed by a single broker-dealer as a sole-managed deal with little, if any, co-manager participation. These underwriters usually provide a warehouse line to CDO issuers and contribute greatly to the ramp up of the CDO securitization. In fact, some warehouse lenders have a major say as to which investments may be put in the CDO vehicle, and at what price.
Simply stated, with few exceptions, the CDO manager and his or her underwriter are usually "joined at the hip" when it comes to the underwriting and flow of information up to, and after, a deal is priced. This symbiotic relationship transcends the entire investment process for the securitization, which includes the guidelines for sharing information with investors.
Where does the liquidity come from?
Some argue that the perceived illiquidity in the CDO market is due to the lack of dealer participation. I disagree. One can count on one hand the number of primary dealers who make active markets and provide "actual" liquidity in distressed ABS. Currently, dealers are making a five to 10 basis point market in certain types of CDOs. I don't consider that liquidity in any serious sense. These wide markets provide pseudo liquidity to investors in that they do not represent true intrinsic value of the underlying securities. Rather, a dealer's stock or inventory bid, as it is sometimes called, has embedded huge premiums for illiquidity.
So, who are the real providers of liquidity in the secondary market for impaired and distressed CDOs? Surely it's not the primary broker-dealer community. Rather, it is the very same investors who have provided liquidity to most other distressed ABS sectors in their time of need. I am speaking of the opportunity funds, hedge funds, opportunistic CDO managers and other asset managers who have dredged through the collapse of the franchise loan, manufactured-housing sectors, as well as past troubles in the home-equity loan, credit card and other "fallen angel" sectors that comprise what I fondly call "the lunatic fringe" of the ABS market. Regrettably, there is one major obstacle standing in the way of an orderly efficient disposition of distressed CDOs in the secondary CDO market, and that is the existing information vacuum!
Lessons from recent ABS debacles
Even though the ABS market is still, in my opinion, in its infantile stage, it has quickly evolved into a resilient part of the fixed income market that has sustained itself and rebound from multiple issuer and sector debacles. Consider the fall of some of the major home-equity loan issuers - such as Conti Mortgage, The Money Store, First Alliance, Southern Pacific Secured Asset Corp., and United Companies Financial Corp. - the recent stumbles in the manufactured-housing sector, such as Bombardier, Oakwood, GreenPoint and Conseco Finance, and the complete meltdowns in the franchise sector, such as Enterprise Mortgage Acceptance Corp. (EMAC) and Franchise Mortgage Acceptance Corp. (FMAC). In all cases, the market took its lumps, only to rebound and become stronger than ever.
With all these major credit blow-ups over recent years, how has the secondary market for ABS been able to flourish without Primary Dealers providing actual liquidity? Simply stated, investors were provided the requisite information, which allowed them to evaluate and purchase securities at levels closer to their intrinsic value, rather than bids from dealers with the illiquidity premium.
The advent of such third-party information providers such as Intex, Trepp, Derivative Solutions and Wall Street Analytics, to name a few, allowed these deals to be modeled so that a thorough credit analysis could be performed. This greatly contributed to the liquidity of this sector.
The real catalyst for a viable secondary market in esoteric ABS has been a willingness of sellers and buyers to generate a secondary market beyond those dealers who brought the deal as a new issue. But, investors require up-to-date information to make educated evaluations. Therefore, they must reject the notion that all information regarding private placements remain proprietary and closed to prospective secondary market investors and traders.
Rather, the investment community must mandate that information cash flows be available on Bloomberg or other venues in the public domain prior to pricing so that liquidity could be maintained in the securities. Underwriters should not be allowed to make the claim of property rights in information that is mission critical for making an investment decision. Such barriers only add to the distrust that exists today between underwriters and investors of esoteric instruments.
The decision by the issuer and underwriter to restrict information cash flows on CDOs is counter-intuitive to an efficient secondary trading market for such securities. This "Black Box" approach on the part of underwriters with respect to new issue deals has been, up to this point, accepted as the status quo by the investment community, and this acquiescence is the root of the problem of the lack of liquidity in this sector. Until investors demand that all cash flows and investor information be provided in a manner that promotes a more liquid market, they will not obtain the true value for their securities in the secondary market if and when they decide to sell.
Haven't we been here before?
Some have referenced the current state of affairs in the CDO market as analogous to the early stages of the commercial mortgage-backed securities market in that those deals were not initially modeled for public consumption. Investors were told that the cash flows and lender information was "proprietary" and that all credit assumptions regarding the cash flows had to be generated internally for "compliance purposes." Investors had to rely on generic Standard Default Assumptions (SDA) that were pre-approved by the underwriters' deal rooms when the deals were marketed. Any customized analysis required a request and ticket to wait in line.
Finally, investors demanded that the cash flows be available for credit analysis. One can point out that some dealers have begun the process to release CDO deal cash flows to Intex and other investors upon request, while other dealers maintain that this information is proprietary to the dealer who underwrites the CDO.
Both positions miss the point. The argument should be to provide all relevant information needed to foster an educated evaluation of the securities in question. Disclosure practices should be framed in a manner that promotes liquidity. Information should be released upon pricing of the respective deals, and trustees should be instructed to provide reporting in a timely manner to all interested parties. There shouldn't be anything to hide relative to the performance of a particular deal.
The amount of principal losses that are being incurred at all points of the capital structures for CDOs is rivaled by the financial chaos in the franchise sector. Sellers, however, who are faced with the prospect of not being able to generate a bid for a particular EMAC bond from the primary dealer(s) who brought their deals can take it upon themselves to furnish all the relevant information to other prospective buyers. They, in turn, will be able to run the prospective cash flows on one of the third-party analytics tools and render an investment decision on the bond. Why can't investors expect the same transparency of information on a sector that has the very same illiquidity?
Investors must demand more transparency of information
What the markets currently lack, but desperately need, that they had during the dark days in ABS, is a motivated investor base that will demand the information necessary for the orderly and efficient trading of CDOs in the secondary market. Too many CDOs have their cash flows restricted or hidden on Bloomberg. Changes must come from within.
Usually, collateral managers for CDOs are also investors in the subordinate traunches in their own deal. I frequently hear collateral managers say that "It's one thing to be a good portfolio manager; it's another to be a good CDO manager." These CDO managers maintain that they have an even greater risk than the "equity" that they usually maintain in their managed deals, namely the reputation risk as asset managers.
Asset managers who are looking to construct building blocks of trust between themselves and investors should start to promote complete transparency of information for their pool of investors, both in the primary and secondary markets. If collateral managers and investors pushed to require that all relevant data for the proper analysis of CDOs be made available to the secondary market with little or no resistance, that would go a long way to instill confidence in a market sector that maintains a cloud of secrecy and mystery that does more harm than good.
Mr. Pastine is a Principal and Co-Head of the Structured Products Group at The Williams Capital Group, L.P., a New York-based investment bank and institutional broker/dealer. He has a J.D. from the City University of New York.
