A need for more information on collateralized debt obligations has been evident since last year when the market witnessed a record number of downgrades.Hardeep Dhillon reports on the moves being made to demystify the product
Toxic. Explosive. Opaque. These are just some of the words used over the past
few years to describe collateralized debt obligations. One word that has not featured
frequently but that many market participants are now trying to add to that list
US private placement regulations have contributed to the lack of transparency
in the collateralized debt obligation (CDO) market by not requiring public disclosure
of information on transactions. This has shrouded the market in a cloak of secrecy,
creating problems for investors in truly understanding the product, which in turn
has caused problems with liquidity.
“There was always a transparency issue,” says Thomas Marx, CDO strategist
at Goldman Sachs. “And the question was how to enhance liquidity when you
did not have much information to work with.”
The lack of information has meant that trading volumes have
been hard to come by because of the secretive nature of the CDO market. Though
some banks have come up with ‘guestimates’ of the size of the market,
a definitive number is still proving to be elusive. Nevertheless, according
to the BMA, the CDO market has escalated from $1.2 billion in 1995 to $246.5
billion in the second quarter of 2003 and is one of the fastest growing segments
of the fixed-income market.
A further barrier to transparency lies in the unusual structure of the instrument.
Because each and every CDO is structured according to unique criteria, no single
CDO is like another. This diversity across the asset class makes it difficult
for investors to get to grips with the product. For Mark Moffat, head of European
CDOs at Bear Stearns in London, the key to the market’s development is to
get investors more comfortable with CDO transactions. CDO investors are recognizing
that they can no longer merely rely on rating agency analyses or simple static
models. It is imperative that they understand the individual credits in their
deals, as well as the particulars of each deal structure, in order to assess each
deal’s return and risk potential.
The Bond Market Association (BMA) is looking to address this problem with the
launch of its online CDO Transaction Library this month. The library will contain
information on specific CDO transactions, which has previously been unavailable
to those outside that transaction.
This resource will enable qualified institutional investors and investment banks
to access deal documents, transaction swap agreements, offering memoranda, indenture
documents, and monthly trustee reports. Currently only 144A transactions will
be posted on the site, but Regulation S deals are expected to follow after certain
legal hurdles have been overcome.
“The goal is to bring efficiency, transparency, and liquidity to the secondary
market by making transaction documents available to dealers and to qualified investors,”
says Nadine Cancell, vice president and assistant general counsel at the BMA.
In order to build a secondary market, trading desks must be willing to make
bids on bonds. But to do so, banks need to feel comfortable about what they
are buying and the risks involved. By providing the transaction documents to
trading desks, banks will be able to model the deal themselves and feel confident
about making bids on the bonds. “The more firms you have making bids, the
more robust your market is,” adds Cancell.
As for the investor community, the transaction library will aim to provide a
single access point for all the different transactions by all the different
dealers. The data from the library will allow investors to model deals too.
“That should help the development of the market,” says Cancell. “Once
the deals are up there [on the website], you will see a big difference in the
liquidity and efficiency in the secondary market.”
Another driver toward greater CDO market transparency is Intex Solutions’
analytics platform. Intex provides an extensive database of deal models, data,
and analytics, covering over 10,000 structured securities. San Francisco-based
Wall Street Analytics provides a similar service to qualified investors, but
only on about 350 deals.
Jim Wilner, vice president of Intex in Needham, Massachusetts, explains that
the firm has to date modeled over 650 CDO deals and updates most CDO deals each
month with asset-level information extracted from trustee reports. “The
analytics are primarily designed for clients to put in different default and
recovery scenarios, and stress-test the tranches of the deals,” he says.
The BMA’s Cancell says the increasing number of deals modeled on Intex
this year has allowed people to check out deals that they do not own, whether
they are dealers or investors. “It is a big change that has definitely
helped the secondary market this year,” she says.
Eight underwriters have released for general inspection Intex transaction documentation
on most CDOs they have lead managed. These banks – Goldman Sachs, Morgan
Stanley, CSFB, Lehman Brothers, JPMorgan, Merrill Lynch, Citigroup, and Wachovia
– account for two-thirds of Intex’s modeled deals, about 400 transactions.
Banks accounting for the remaining one-third of deals have not yet agreed to
allow their data to be made public.
Wilner says that Intex has almost completed its job with US cashflow deals and
that the firm is now beginning to collect data on synthetic and non-US transactions.
“The increased transparency provided by Intex is very positive for the
CDO market. Intex puts analytical capabilities in the hands of investors in
an efficient and user-friendly way,” says Ross Heller, vice president on
the CDO syndicate and trading desk at JPMorgan, the most recent addition to
Intex’s client list.
And more banks are set to follow. Speaking at a BMA’s CDO conference held
in New York in September, representatives from Bear Stearns and UBS stated that
they were also considering posting deal documentation on Intex. “Almost
every bank has posted their deals on Intex; it is something that cannot be ignored
and I expect the remaining banks to follow suit,” says a CDO banker. “This
would be something of a change of course for Bear Stearns, which has its own
CDO valuation model.”
These initiatives are stimulating a nascent market in the trading of CDOs. Early
secondary market activity – namely trades done prior to June 2002 –
consisted mainly of agency trades done on a best-effort basis.
Some investors, who experienced a period of consistently high default rates,
were motivated to sell because they viewed the risks that they held to be different
from when the deal was originally launched. One recent example is Pacific Investment
Management’s liquidation of Abbey National’s $16 billion CDO portfolio
However there has been other more conventional secondary market activity this
year, particularly in senior tranches. Bankers estimate that about $1 billion
of senior CDO paper has been traded. Other tranches, such as mezzanine notes,
have been on the increase too.
For Goldman’s Thomas Marx, the mere existence of secondary trading desks
at banks is a good illustration of liquidity in the market. The major underwriters
are responding to increased demand from new investor types, such as principal
finance desks and hedge funds.
Soros Fund Management and Cargill Investor Services have most recently been
rumored to be bidding for CDO paper in the secondary market. And this is all
good news for a market that was previously predominantly dealer driven.
Hedge funds have constituted the fastest-growing investor base in the CDO universe
because they have the structural expertise and ability to move quickly in the
market. They are natural buyers of distressed senior collateralized debt obligations
due to their analytical ability to break down CDOs. Many investors have stayed
away from the market because of the amount of analysis involved.
“Each year you see developments,” says Marx of Goldman Sachs. “Now
with systems that allow for daily analysis, with clients demanding that dealers
share more information, and increased supply of seasoned CDO tranches in the
market, you are seeing dramatic growth in the secondary market. This will help
transform the market into a more efficient one.”
What’s on offer in the CDO market
Deal modeling platform. Updates data on the transactions on a regular
basis, usually monthly, with information on the asset and liability sides.
650 deals, open to non-investors of CDOs.
Wall Street Analytics
Deal modeling platform that allows investors to run price-yield analytics,
project cashflows and coverage tests, download collateral information,
and track exposure across portfolios of CDOs. Has a library of over 350
Credit modeling of the collateral portfolio with detailed handling of
the CDO waterfall structure. Produces individual tranche performance distributions,
fair-pricing levels, shadow ratings, and sensitivities to individual issuers.
Cashflow modeling and analytics systems that allow default and recovery
scenarios to be applied to portfolios and yield outputs to be viewed.
Provides diversity scores, weighted average rating factors, monthly performance
data on CDOs. Planning to put out a CDO performance data model that investors
can use to evaluate CDOs.
Standard & Poor’s
Provides information on the underlying portfolios, but also pre-sale reports,
manager focus reports and performance measures. CDO Evaluator examines
how portfolio credit quality is impacted with changes in a portfolio’s
ratings, maturities, levels of industry diversification, and size of individual
Manager rankings, pre-sale and rating criteria reports. Default Vector
Model allows investors to examine portfolio credit quality.
Real-time data providing bid-offers on 182 markets to aid transparency
of the underlying credits used to price CDOs. Used by 90% of the trading
Bond Market Association
CDO Transaction Library provides information on specific CDO transactions
previously unavailable to those outside that deal, including swap agreements,
offering memoranda, indenture documents, which outline the responsibilities
of all parties involved in a transaction, and monthly trustee reports.