In the past year, unprecedented downgrades of senior CDO tranches caused many investors to ask: Does a triple-A rating imply less volatility?
Rating agencies have typically said no, though there is perhaps agreement that triple-A ABS has shown more stability statistically than lower-rated classes.
What's more baffling in CDOs: Why do these vehicles, which have defied all rating assumptions and skewed migration studies, continue at the current clip (cash and synthetic issuance totaled approximately $120 billion issued worldwide last year, according to one panelist)? This question was asked in some form or another in the three CDO panels at American Securitization Forum's ASF 2004.
Participants in the "Case Study of CDOs" panel said that the negative period of credit risk the sector is undergoing currently is similar to what the conventional CMO market went through in the mid-1990s. During both periods, issuance volume continued despite the setbacks.
In terms of the rating downgrades, panelists in the "CDO Researcher Roundtable" said that it's not a matter of the agencies being right or wrong, but more what was promised and what was actually delivered. Often, because of the volatility in the underlying collateral - default rates in the different sectors underlying the CDO vary from time to time - ratings are no longer absolute measures of credit risk. In fact, Moody's Investors Service has said that the yield of the underlying bonds is a better indicator of defaults. So the highest yielding credits are what investors should pay close attention to.
Also, recovery rates are quite high on triple-A rated tranches in the sector, thus they might be undervalued in the market. However, it is not just a matter of ratings volatility, panelists argued, as some former triple-As do exist that will not see full recoveries.
A panelist in Tuesday's session titled "CDO's New Trends" said "the probability of default determined by actual market information is more telling because it is more sensitive to changes in the underlying collateral." This panelist echoed the comments of others in earlier panels that historical ratings are not the best basis for determining the probability of default.
Despite appearances, however, there still must be some logic to this business.
"The logic is to say CDOs are not an asset class but they are simply a very efficient way of leveraging credit," said Gyan Sinha, senior managing director at Bear Stearns and a participant at the "Case Study" panel. Sinha said this factor has been responsible for the market's resilience. So if an asset class is encountering problems, there are other alternative asset classes that could be collateralized. This is why ABS and CMBS-backed deals are gaining ground now while high yield deals are out of style. "There is nothing wrong with the technology, the market just has to find the right asset classes to put into the technology," said Sinha.
In the researchers' panel, Sunita Ganapati, senior vice president at Lehman Brothers, concurred, noting that underperforming sectors are not the drivers of growth. High yield and emerging-market CDOs, for instance, have gone the way of Bennifer.
Growth is actually coming from leveraged CDOs, structured finance CDOs and synthetics. Other factors encouraging growth include the seemingly insatiable demand for credit products and the global growth of the investor base.
The researchers pointed out
some positive market trends, including the significant infusion of liquidity into secondary markets. Currently, six dealers are actively trading in the secondary market, as opposed to only two before. Also, an exit option is now present in the most senior part of the capital
structure, so people are coming in, panelists said.
Another trend cited by researchers: the proliferation of single-tranche CDOs, which reportedly provide more flexibility for issuance. Analysts said that many banks may have had too much exposure to undesirable credits and the single-tranche structure provides an avenue to sell these names. The single-tranche CDOs came about because people did not want to buy whole portfolios that were picked through by the market, researchers noted.
However, these deals have one disadvantage - they are not based on a correlation model. Moreover, it's possible that one name, such as Parmalat, could destroy the value of an entire transaction.
Participants at the "Case Study" panel examined current spread compression in the underlying structured finance collateral. Triple-B subordinate home-equity spreads, for instance, at 300 to 350 basis points over Libor last September, are currently trading at the 180 basis point range over Libor. On the asset side, the cost of funds has become greater than the all-in yield.
Because of this phenomenon, panelists said that the security selection of the manager has become more important today.