While growth in the asset-backed CDO market in 2005 soared - with some underwriters posting triple-digit gains in sales (see cover story) - the downside was often the difficulty faced in finding collateral fast enough and of high enough quality to make deals happen. Collateral spreads through most of the year remained at historically tight levels, creating an at-times challenging terrain for achieving arbitrage and even prompting some managers to pull out of the market altogether.
Regardless of the varying opinions on which bonds were best at which enhancement levels, this year's ABS CDO Deal of the Year was chosen because of its precedent-setting innovation, which led to faster and more diverse collateral sourcing in a highly competitive, and at times controversial, atmosphere.
The honors went to BlackRock Financial Management's Tourmaline CDO, the first marketed CDO considered to be a true "hybrid" deal to come to the U.S. market with both unfunded and funded assets and liabilities. Morgan Stanley & Co. brought the deal to the market.
Tourmaline was the first hybrid CDO backed by mezzanine ABS, according to Morgan Stanley. Sixty-five percent of the deal's assets were unfunded CDS, while 65% of the liabilities were in the form of an unfunded liquidity facility. The deal, which priced through the tight end of similar cashflow ABS CDO transactions, was so popular among investors that it was upsized to $750 million from $500 million.
The Tourmaline deal priced on Sept. 2, closing shortly after the similar Commodore IV, underwritten by Deutsche Bank and managed by Fischer Francis Trees & Watt. Industry participants said it seemed to grow legs throughout the market and prompted a host of deals such as the Duke IX CDO, managed by Duke Funding Management and underwritten by UBS.
According to analysts at Moody's Investors Service, Tourmaline is among the most famous of the true hybrids to hit the U.S. market. "Basically all the banks are looking to do one, and the ABS managers are looking to do these as well," said Yuri Yoshizawa, a managing director at Moody's.
One of the most public examples of a CDO manager leaving the market because of difficulty sourcing collateral was Pacific Investment Management, which was the fourth-largest CDO manager as of year-end 2004. The Newport Beach, California -based asset manager said last spring that it would not manage any new deals. To PIMCO, a combination of tight spreads and what more than a few analysts viewed as deteriorating credit quality created "an awful lot of moral hazard in the sector," said PIMCO managing director Scott Simon. "You either take the high road or you don't - we're not going to hurt accounts or damage our reputation for fees." (see ASR 5/9/05)
But other collateral managers, such as Trust Company of the West, pointed to an abundance of investor demand for ABS CDO product - particularly overseas -and argued that resiliency within the U.S. housing market would persevere through rising interest rates, new products and a host of new borrowers. "There were a number of firms at the beginning of the year that well publicized their aversion to issuing in the market," said Lou Lucido, a managing director at TCW, "but those risks did not surface in 2005."
Meanwhile, the International Swaps & Derivatives Association's release of formalized contracts for pay-as-you-go settlement procedures has enabled CDO managers to model liability structures of synthetic deals after cash deals, causing a surge in the structures that started in the second quarter, Standard and Poor's Director Belinda Ghetti has said. (see ASR 11/21/05)
"The use of synthetics in the context of a cash CDO of ABS enables easier collateral selection and sourcing, and a more efficient liability funding cost," Ghetti said. Most hybrid transactions exhibit the same cash CDO structural features - such as collateral quality tests and diversion triggers - of fully funded cash CDO of ABS, but the major difference is the use of an unfunded super-senior tranche in the capital structure, which introduces a cheaper funding source for the CDO, Ghetti added. The unfunded synthetic assets in the Tourmaline deal, for example, helped to bring as much as 13 basis points in savings to the top 65% of the capital structure, according to Morgan Stanley.
Another innovative structure to hit the market this year was the long/short CDO. First brought to the market through State Street Global Advisors' Diogenes CDO I in September and then again through TCW's Dutch Hill Funding deal the following month, the structures incorporated long cash baskets with short CDS of single names and corporate indices.
Both deals incorporated long RMBS cash buckets with short buckets that synthetically referenced corporate indices and single-name entities with exposure to the RMBS market.
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