Coming off a less than stellar year for CDOs, market watchers are anxious to cast nets in waters teeming with life. Their best fish-finder, it seems, may be the increased use of "customization."

As has always been the case, collateralized debt obligations are instruments that offer a level of customization by their very nature, as the collateral manager chooses (according to guidelines) the assets backing the bonds. This fact, according to banks at least, has been the fundamental draw for investors - CDOs are structures that create custom exposures that investors desire but cannot find elsewhere, as JP Morgan Securities researchers like to put it.

What's evolved lately, however, is the increased application and understanding of CDO and synthetic technology by investors, allowing them a new world of portfolio management tools. Rather than utilizing third-party collateral managers, who are an important party to most of today's deals, some investors have been coming directly to the investment banks looking for custom exposures using CDO structures. While collateral managers such as Pacific Investment Management Co. will hardly be shunned in droves, these more sophisticated investors are comfortable enough with CDO technology that this trend, according to Morgan Stanley's Sivan Mahadevan, is akin to "financial engineering." In fact, the investment bank pointed to it as one of the primary factors that will drive the 2003 CDO market.

"What we think is interesting, and where there's going to be a lot of growth opportunities, is in using this technology on a client-specific basis," said Mahadevan, head of structured credit and CDO research at Morgan.

A management team at an insurance company, for example, in charge of a $1 billion portfolio, has decided it wants to change the risk and return profile of that portfolio. The investment bank can put together a customized transaction allowing investors to alter the portfolio themselves, minus the middleman manager. "So it's their portfolio, it's their tranches and attachment points that they feel comfortable with. And they can even customize a risk/return profile. The dealer is effectively providing a financial engineering solution to the client," said Mahadevan.

This sort of customization is different from traditional balance sheet deals because investors are tailoring the products specifically for themselves, dealers are hedging or trading tranches in the capital structure, and transactions are getting done quickly involving just a few parties.

"In some sense, because this product has matured, there's been a lot of advances in thinking about how to trade and hedge these products and therefore we're able to do these things for clients now," said Mahadevan.

Demand for customization became evident last year, and Morgan Stanley predicts momentum will drive through this year, particularly as synthetic investments are gaining favor.

"A lot of this is really in the synthetic world, investment-grade synthetic credit," he said. "It really has a lot to do with people who have investment grade portfolios; they can do these sorts of things with synthetic structures," he said.

As more investors enter the market and grow savvier in CDO structure, more dealers will likely be offering this product this year.

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