Last week, Wachovia Securities let the CDO market glimpse its APEX structure and issuance platform. Apparently, APEX is testament that the CDO market is evolving such that the interests of CDO equity investors are more aligned with debt tranche holders. While this measure is not seen as a cure-all for the sector, it is a step in the right direction to right this wayward market.
In a recent structured products research piece titled "Enhancement Through Structural Change," Wachovia research analysts Nichol Bakalar and Jeff Prince explain that three derivatives - balance, credit and income swaps - are blended together and essentially act as a single instrument, dubbed the "APEX Swap," to further balance the interests of parties involved in a CDO.
The APEX swap acts as a credit line for the collateral manager to tap in the event of a trading loss or default in the portfolio, and is repaid by the excess spread that would typically flow to C class subordinated debt investors. Protecting the C class notes as well as the swap counterparty is a "restricted investments" bucket consisting of triple-A rated floating-rate collateral. At maturity or call, this is liquidated to pay the APEX swap counterparty, and then retire the bonds.
The swap counterparty then forwards losses on defaulted securities to the collateral, therefore giving managers the incentive to unload positions and reinvest quickly. Since this arrangement makes whole the collateral manager for the loss it incurs, the manager is able to reinvest in higher-quality bonds trading closer to par. Afterwards equity cashflows repay the counterparty. This relationship effectively creates a zero O/C cushion for the manager.
"We developed this structure because we realized there is natural tension between equity holders and debt holders, especially in transactions that are struggling," said Wachovia's Prince. "We wanted to create a structure that encouraged a collateral manager to focus more on credit decisions and less on structural nuances."
While not entirely new to the CDO market, the APEX structure is the first to combine traditional CLO structure with credit derivative technology all within the same trust, Wachovia contends. And others agree, "APEX is the perfect marriage between market-value methodology and credit-default swap technology," said Paul Forrester, a partner who heads the CDO effort at Mayer, Brown, Row & Maw.
The fact that derivatives technology has previously been adopted by Banc of America Securities (Serves), Bear Stearns (Gallaton) and JPMorgan Securities (Sequils/Minx), makes this a bona fide trend for the future of the CDO market. But by nature, this structure is not an option to all, as the large balance sheet and the ability to act as swap counterparty are available to only banks and large insurance companies.
The complexities of past structures have limited the appeal to investors, sources said. For example, the Sequils/Minx, technically separate offerings placed in tandem, is considered confusing to the traditional CDO investment community. "With no equity whatsoever Sequils uses the swap counterparty in Minx to act as the economic equity holder," explained a buysider.
According to Mike Garity, senior director in the Fitch Ratings CDO group, there are three to four banks that have expressed interest in setting up similar enhancements within CDO vehicles. The main barrier to entry, aside from the balance sheet capabilities, is the swap counterparty capabilities, which, Garity adds, has to be rated F1+ (its highest rating) for Fitch to rate the CDO.
Merrill Lynch structured finance research head Dan Castro agrees that this is likely the future direction of CDO structures, noting, "CDOs will see more cash-trapping built into structures." While he views this as a positive trend, Castro stressed that regardless of the structural enhancements built into a deal, "at the end of the day, it's about the collateral."
What these protections do, Castro added, is keep collateral managers, equity investors and debt holders on the same page throughout the day-to-day operations of a transaction. In the long-term, however, "These enhancements protect the debt investor at the margin, but a CDO is only as good as the pool backing it. With a bad collateral pool, these enhancements just prolong the agony," he added.
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