The CDO market continued to grow at a furious pace in the first half of 2001, but in the foreground of the two to three CDOs that priced each week on average, a barage of rating agency credit watches and downgrades kept a sober mood around the product.

Prior to the first quarter, an investor could take comfort that a triple-A CDO tranche had never been downgraded. Now we can say six triple-A rated CDO tranches have been knocked down to double-A. And most recently, Delaware Investment Advisors saw Standard & Poor's whack their rating on CHYPS 1997-1 CBO to single-A from triple-A - an unfortunate first for the marketplace.

The historic CDOs include arbitrage deals; BISTRO 97-1000 (A), Eisberg Finance 1 (A1), ML CBO XVIII (AIG) 98-2(A1), ML CBO XVIII (AIG) 98-2(A2), Northstar CBO 97-2 (A2), and Steller Funding CBO Corp 1A (A3) and CHYPS 1997-1 CBO (A-2A).

"You have to be a real dog' of a manager to lose money for the investors at the triple-A tranche level," said one investor in Europe who buys CDOs for a bank portfolio. "We buy at the top of the payment waterfall - triple-A and single-A - because we don't trust these structures enough to go lower."

The number of downgrades witnessed, particularly from the 1997-1998 vintage, has never been higher. For example, 33% of Moody's Aa2-rated CDOs and 39% of the Baa3-rated CDO from the 1997-1998 vintage have been downgraded. Moody's attributes the severe downgrade pressure to a simplistic "common theme that CDOs that closed during that period paid dearly for their assets."

Meanwhile, high event risk pressures in the corporate credit market triggered downgrades on 26 tranches of balance-sheet CDOs - half of all downgraded tranches in 2001.

While having a deal on review or downgraded by the rating agencies makes marketing new CDO issues more difficult for those who have had problems and didn't work them out successfully, this hasn't discouraged some asset managers from returning to the market. Currently several U.S.-based firms, such as Conseco, Pacific Life Insurance, and Highland Capital Management have deals in the pipeline, despite some rating volatility. Even managers with colorful reputations of managing the CDOs underlying portfolio to protect the equity holders at the detriment to the debt holders have been able to return to the market.

One of the most controversial aspects of the CDO business is asset managers selling and buying assets at steep discounts to make their overcollateralization tests, a failure in which would result in cutting off cashflow to the equity investors. "It really depends on the psychology of the person making the decisions at the asset manager, who they are going to protect first (the equity holders or the debt holders)," said one collateral manager. Issuers are typically required to invest around 25% in the first-loss piece of a new CDO, which the Street refers to as skin in the deal'.

Meanwhile, some seasoned investors believe the downgrades in CDOs is a good thing, bringing some sanity to the business. Back in 1997 and 1998 there were a host of investors who had no idea what they where doing and were buying up CDOs based on ratings, a sure recipe for disaster, said a head portfolio manager with more than $5 billion in CDO exposure.

"We work hard to have structural protections added into deals we participate in and will walk away if we cannot see the underlying portfolio," the investor said. "However, with a growing crowd of CDO investors it has been getting more difficult to bargain for added strengths such as more diversity or vintage limits. "

Another challenge to CDO investors is the fact that rating agencies are by no means not-for-profit organizations and that bankers are famous for threatening to kick out an "overly" conservative agency on a deal.

"One of the largest rating agencies told us that they rely on proactive investors to help make the CDO structures tighter," said one portfolio manager, who spent several hours going over the structure on a new a arbitrage CDO. "These are our clients and we can't bargain every point with these parties," the senior rating analyst reportedly told the investor who was pushing for a more conservative deal.

To be fair, rating agencies are not required to make a CDO structure bulletproof. On the other hand, the volume of CDO deals in the queue is unprecedented, and the fast turnaround time required by bankers and rating agency management leaves room for important structural risks to be missed.

Buysiders have a variety of anecdotes on their strategies to avoid getting involved in troubled deals.

"We do not buy CDOs from managers who wear junky jewelry," is one unofficial rule at Bank Gesellschaft Berlin, according to John O'Grady-Walshe, head of structuring and investment of securitization. "Boring is definitely better," just as you wouldn't want to buy insurance from a guy driving a red sports car. "We look for collateral managers that take a serious approach to credit selection - focusing on people," added Walshe. "We also look for a structure that isn't going to penalize a manager for doing the right thing," referring to the ability of the asset manager to buy or sell assets to improve the performance of the portfolio.

Other investors say they stay clear of problems by only buying collateralized loan obligations for their stability and higher asset recovery rates compared to bond deals.

"We stayed clear of market-value CDOs and have stuck with CLOs and have been very fortunate to have not had any problems with our CDO holdings," said one portfolio manager at a medium-sized life insurance company.

According to sources, one frequent issuer of CDOs of CDOs employs a strategy of buying their collateral in the secondary market after 18 months of data is available and detailed trustee reports can be analyzed. Sources say there are billions of dollars of CDO paper available in the secondary market that are on sale for a variety of reasons, including a change in strategy, mergers, and deals breaching rating agency collateral tests.

"The fate of the CDO is often determined early on in the transaction's life as the assets are selected prior to closing and shortly after," said David Tesher, managing director for cashflow CDOs at Standard & Poor's.

The success of the asset selection or ramp-up depends on multiple factors, namely the economic environment and the ability of the asset manager to buy assets with sufficient excess spread that can satisfy the internal rate of return profile marketed to the equity investors. It is important to note that the inability of the asset manager to acquire assets cheap enough may cause the manager to take on more risk and leave less room for error.

There's no secret recipe for avoiding buying a CDO that may run into future problems. In the past some investors thought if they stuck with big asset managers they would be safe, but this hasn't been the case, considering the insurance behemoth American International Group has a CDO that lost a triple-A rating.

S&P's Tesher said that he has seen CDOs from small shops perform better than deals from managers who are part of larger organizations, which have interests that extend beyond managing a CDO.

"Equity investors today are clearly in a better place to pick and choose managers they want to invest in," said Tesher, who went on to say that some managers who come to market more than once "are rotating their investment banks to broaden their investor base.

"Even with the lucrative spreads available on the underlying high-yield collateral that goes into high-yield CDOs, it's still extremely difficult to place the pivotal first-loss and subordinate tranches of these structures, as investors are still uncertain regarding the near-term economic landscape," he added.

Nevertheless, for the right manager who is going to do a good job and balance expectations, the equity can be oversubscribed, according to Street sources. Then there are the issuers who want the returns on the equity for themselves. Deerfield Capital, a U.S. asset manager, holds up to 40% of the equity in their transactions for themselves or affiliates. Also, C-BASS, a U.S. subprime RMBS servicing and investment shop, has issued two CDOs and has reportedly retained 100% of the equity in both deals.

According to market talk, underwriters that are willing to put equity on their books have a boost in the persuasiveness of their pitch for mandates.

"Once you sell the equity in the deal you're done, you can always find someone to buy the investment grade stuff," said one CDO banker specializing in investment grade CDOs.

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