While the primary CDO market has been largely guarantor-free for the past several months, behind the scenes the monolines are wrapping new issues in the secondary market shortly after close.

XLCA guaranteed senior class portions on five deals in the first quarter, for about $575 million in par written. These policies are generally applied within three to five months.

The demand for the secondary wrap is split about 50/50 between investors and dealers, said XLCA's David Czerniecki, who focuses on CDOs at the triple-B bond insurer.

While the secondary wrap is not necessarily a new development, the motivation for the product has changed significantly since late 2002, when the market was more credit- sensitive and new-issue CDOs often left the gates guaranteed.

A monoline professional apart from XLCA said that in past years, dealers often paid for protection on portions of CDOs they were unable to place with investors. In the current market, when transactions can be four or five-times oversubscribed, the underwriters are often maintaining positions for the value.

In the current environment, the banks may solicit a guarantor for a portion of a tranche sold to a group of investors, without impacting the rest of the capital structure and subordinate classes.

"The interest in the primary is where things are less commoditized," Czerniecki said. "You're seeing demand today in middle-market loans, emerging markets and other off- the-run asset classes."

A large portion of the protection buyers come from the ABCP securities arbitrage market. As most of the secondary guarantees are placed on natural triple-A rated classes, the arbitrage conduits are mitigating rating transition risk. Conduits have historically been strong buyers of the senior classes of CDOs, though they entered a cautious period after getting burned by the volatile late 90s and early 00s vintages. Conduits can quickly become forced sellers if their assets drop in credit.

One of the main differences between the traditional primary issuance wrap and a secondary wrap is that the guarantor does not enjoy the same control provisions that accompany primary bond insurance. In a sense, the secondary wrap is more akin to a direct position in a bond, depending on the attachment point and size.

XLCA is primarily participating in natural triple-As. Czerniecki emphasizes the size of the position as a consideration.

"If you wrap a significant portion of the senior tranche, you're going to be the controlling party," he said. "For the most parts, the rights of the controlling class are similar to those of a primary monoline, though there definitely is a little bit of a give-up."

Often, a secondary wrapped bond will carry a modified CUSIP, which indicates the piece can trade without losing its guaranty. Other policies may be written for a specific investor, more in line with buying credit protection for a set duration.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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