Bit by bit, more light is beginning to shine through what is arguably the most opaque corner of the CDO market - equity tranches. Helping matters are some initiatives from market players including Moody's Investors Service's recent announcement that it would begin tracking CDO equity return data. Furthermore, Wachovia Securities - whose analysts were concerned that Moody's data reflected bleaker-than-realistic returns - took that information a step further in order to ascertain more precise figures.
These are welcome developments as it is typically quite difficult to gather both performance and pricing data on the lowest portion of the CDO capital structure. This is because the pieces are generally unrated and relatively illiquid compared with triple-A CDO notes.
A main driver of lower reflected returns in the Moody's data is that the rating agency assumes that the equity of deals that have yet to terminate is worth nothing - a move prompted by difficult or even impossible-to-ascertain market value prices of outstanding equity tranches. But Wachovia used Moody's data to try and back into par yields and prices.
Wachovia's point of view
"While it is probably the case that many of the old vintage CBOs are worth (next to) nothing, we expect more recently issued deals to be worth between 80% of their face values to over par," Wachovia analysts wrote in a report released last week. Brian McManus, director and head of CDO research at Wachovia, said if Moody's does not pick up the additional analysis performed by Wachovia to enhance its monthly reports, the bank would likely continue to use its own researchers to do so.
The more in-depth analysis was comparable to conclusions investors can already draw from surveillance data and CDO note ratings migration, Wachovia analysts found. Some of the key points were that those deals issued within the last three to four years have enjoyed stable ratings as well as relatively robust equity returns and that pre-2002 vintages varied by asset class, manager and structure, McManus said. The team found that equity tranches with the lowest credit enhancement levels tended to perform most in-line with Moody's estimates while better performing tranches earned a higher rate of return through the Wachovia analysis, he said. Deals falling in the middle showed mixed results.
As far as what can be learned from historical equity IRR data so far, McManus said the key will be for CDO managers to successfully navigate a balance that will allow a long enough window for high yielding collateral to pay off equity investors before defaults begin to defer cash flows to more senior tranches. "This is a challenge for CDO managers right now, and this is what is clear from looking at these figures from CLO and ABS CDO land," McManus said.
For example, using its own models to assume loss, prepayment and delinquency projections for subprime loans, Citigroup Global Markets analysts last month estimated that most subprime bond defaults will be back-loaded, creating a relatively long period of time before losses are realized. The investment bank's analysts subsequently recommended that would-be equity investors seek out a well-managed deal backed by a geographically broad pool - and a rate of return in the range of 20% in order to catch front-loaded returns.
Still, the demand for the risky CDO equity continues to be strong. "When I took this job at Wachovia Securities, one of the first things an investor said to me is that nobody ever publishes equity returns," said McManus, who was speaking by phone from Korea. "And here over in Asia, I'm (hearing) from the salespeople -'what are the equity returns?" In September, McManus moved to Wachovia from Merrill Lynch, where he was a CDO analyst.
Despite difficulty finding historical performance data, a hunt for yield throughout the structured finance market, coupled with the relatively benign credit environment of recent years, has made equity investment appealing to a number of new investors. While both projected and historical return-on-equity data is available to the market in various forms, the announcement by Moody's late last month that it would provide monthly return-on-equity reports - called the Moody's Equity Score Report - constituted the first rating agency attempt to consistently chronicle such equity performance indicators as internal rate of return, dividend and yield distributions and the most recent year's equity payment.
In its first report, Moody's analysts found that emerging market CDO equity pieces yielded the highest returns compared to other asset classes, while high yield CBOs were more likely to disappoint their investors. The most likely candidates for poorly performing equity were deals that buckled under poorly performing collateral, resulting in early paydowns for senior tranches, and those that contained tranches which were not paid in full.
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