The temptation for cashflow CDO collateral managers to engage in abusive par-building trades is heightened, Standard & Poor's said last week as it released a study/commentary on the trend.

In its most talked about form, a par-building trade happens when a collateral manager purchases a discounted asset and marks it to par, improving the CDOs overcollateralization ratios. Note holders and rating analysts associate abusive par-building trades with managers who favor their equity investors - as gaming the O/C levels allows them to preserve the cash flow, mitigating the debt holder protections built into the structure.

While par-building trading strategies have been utilized by CDO managers for years, the current economic backdrop has fueled their use, as the deteriorated credit environment and rising defaults are hitting corporate-backed CDOs particularly hard.

"Pressure on CDO managers is significant, given multiple constituencies and the constraining investment parameters inherent in CDO structures," writes David Tesher, Fixed Income CDO group head at S&P.

One of the bigger challenges is differentiating between aggressive abusive par-building trades and legitimate opportunistic purchases as they take place. Interestingly, when they take place is often an indicator as to a collateral manager's intention. For example, S&P is weary when unusual trading patterns occur, such as deep-discount trades, just before an O/C determination date. Also, a manager suddenly making purchases in an unfamiliar asset class type is a red flag, Tesher added.

Mechanisms and enhancements

Also last week, Moody's Investors Service released a special report on enhancing CDO ratings stability, in which the agency addresses structural mechanisms that limit a manager's ability to make abusive trades. For example, Moody's suggests that the purchase of deeply discounted securities could be funded by excess interest only. Also, limiting the mark up (or requiring managers to mark an asset at its purchase price for O/C calculations) would hinder the potential for abuses, though it would also inhibit positive par-building trades.

As S&P's Tesher notes, certain par-building trades in the long run benefit both the equity and debt holders. For example, a manager might sell out of a high-coupon performing asset at a premium, and reinvest in cheaper performing paper bearing a lower coupon, using the premium proceeds for additional collateral.

Of course, the risk of overly stringent price marking requirements (for O/C tests) is that the cashflow CDO will start to look like a market value deal. At its core, a cashflow CDO is a buy-and-hold vehicle, designed to mitigate market price fluctuation.

"Another possible solution involves back-testing of deeply discounted purchases and restricting future purchases to the extent that those securities ultimately prove to be credit risk [or securities that the manager believes will default in time]," Moody's writes in its report. "Discounted securities are not necessarily a severe risk as long as the structure anticipates such securities. However, at this time, most CDOs do not."

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