IFR: How has the cash-flow CDO market developed in the US this year in terms of collateral demand and the structuring of assets in deals? Has that presented rating challenges?
David Tesher (S&P): From a cash perspective the challenge in the market, whether it is on the corporate side or the ABS side, has been the spread component. There has been a significant amount of compression in the spread on
ABS assets as well as on leveraged loan assets. Regardless, we continue to see a robust pipeline for leveraged loan CLOs and CDO of ABS transactions. From a corporate backed perspective, we have rated for the first eight months of 2005, 48 CLO transactions versus 38 transactions for the same eight months in 2004.
With respect to the CDO of ABS, which is the other mainstay of the cash CDO market, we have rated 55 transactions in total for the first eight months, versus 39 for the comparable eight month period of 2004. Standard & Poor’s has rated more transactions in totality in 2005 for the first eight months versus 2004. What we are also seeing is that the size of the transactions has increased again.
We have seen a significant amount of liquidity being provided at the senior part of the execution. In rated issuance volume for 2005, if you look at the first eight months, we rated US$24bn versus US$14bn. For the full year 2004, in the case of CLOs we rated 66 transactions in total. We already in 2005 rated 48. In terms of notes that we rated for the first eight months, we already have matched the full year in 2004. We rated US$24bn in 2005 for CLOs versus US$26bn for the entire year 2004.
In the case of CDO of ABS, we have already rated 55 transactions as of 8/31/05, versus 80 CLOs rated for the full year 2004. We are going to exceed clearly the transaction volume rated in 2004, but from a total rated issuance perspective, we have already rated US$43bn versus US$46bn in 2004. Liquidity is significant. Negative basis investors are at the senior part of the capital structure. Resecuritisation vehicles are at the second priority and mezzanine levels. And the credit hedge fund is participating throughout the capital structure.
What effectively is occurring is a situation where managers are now chasing assets for their new and vintage transactions in their revolving periods. Spreads have compressed significantly as managers fight to source assets.
IFR: From the bank side what is changing about the way you put deals together this year?
Mike Llodra, (BoA): There has been significant change. Spread compression has made the economics of the transaction a little bit challenging. Heading into this year we had a good headwind of development of high-grade asset backed CDOs, we had strong momentum in the CLO market. It will be interesting to see how that translates into next year. Whether those trends continue, or whether spread compression and some of the challenges that we as bankers have are going to slow deal volume down a bit.
IFR: And what’s your early take on that?
Llodra: No.
Jim Kane (JPMorgan): My personal view is that the biggest struggle now is collateral sourcing and finding assets that have enough differentiation relative to the rest of the market. That can then put us in a position to continue to grow either new investors, which will then by definition help either drive down liability spreads or drive down required equity returns in line with what’s happening on the asset side of the equation.
So predominantly it is an asset differentiation versus lack of differentiation issue that we are spending a lot of time trying to solve for how to find those assets that are out there that have yet to be securitised, or find opportunities with managers that may have differentiated ways to source assets that are different from the broader marketplace.
Llodra: I think it is interesting that the equity returns and required equity returns that we need as bankers to source equity in an interesting and durable way – those yields haven’t really come down. And there are no pockets of money that we are finding globally that are willing to take a sub 10% return versus the 12% or 13% return that they wanted in a higher spread environment. That really has nowhere to go. We have to come up with structures and collateral and an ability to maybe improve efficiencies in transactions to continue to develop global demand for equity. Otherwise that is going to be at some point a carburetor on growth.
Tesher: I think a very important aspect of today’s marketplace are the structural mechanisms that have been incorporated into the transactions which are intended to shut down excess spread, as a deal experiences rating migration or credit deterioration. It is important that equity investors be aware of the fact that they may end up not receiving a current distribution at a given point in time, if there is some credit migration or par erosion. Obviously, there is will always be a natural tension between the debt and the equity, but I think it is very important that this tension remain healthy, as opposed to the unhealthy tension that played out in the mid-1990s with some of the high yield CBO deals.
Unfortunately there is a potential for unintended consequences. The presence of such mechanisms, such as a Triple C haircut in the case of a leveraged loan deal, should not however result with the manager engaging in trades that may not ordinarily make, simply because they all of a sudden are afraid that they are going to have less leverage in the structure.
We are looking for managers who are able to balance the tension between the debt and the equity.
Lang Gibson (Merrill Lynch): We are seeing this 80% growth rate in US cashflow CDOs, like we did last year. The big picture issue is that investors are reaching for yield in what has been a very benign credit environment for a prolonged period. I mean very low collateral downgrade and defaults, and CDO downgrades have been very few and far between.
But one thing that is facilitating the supply of securitisable collateral for CDOs is basically the expansion of synthetic technology to all kinds of structure finance assets. Around 50-58% of the new issue volume is ABS CDOs. If you can buy a new, expanded asset class, then clearly that is going to facilitate volumes. They can now get better relative value in the deals. Even though spreads are very tight, they can get a better choice of securities to pick from. Basically, they can pick from any vintage, any deal that they want. They can go down a list of previously issued CDOs such as home equity ABS, and reference these in the transaction. We are seeing them in a 20-35% bucket for cash flow CDOs, we are seeing pure synthetic ABS CDOs.
Clearly that is helping issuance this year. The question is how long will that last? There is protection seller demand in the ABS CDS market, but there is only so much protection buying demands. Hedge funds take the other side of that trade, speculating on US consumers, but how much of that can continue? Probably when spreads start widening again protection buying will actually accelerate. But if spreads stay tight for a while, you might see a limit to that appetite.
IFR: Is it a full enough product suite, or is there anything missing in terms of what the bankers are offering?
Tracy Pridgen (FGIC): As an investor, and primarily as a senior investor, since I work out of a monoline platform, the risk is somewhat muted because across the board we tend to be involved in the Triple A tranches, but there is still risk embedded in the transaction.
There is a question as to whether there were deals that were done in 1998 and 1999 that would not have been financed in a less frothy environment. There is a question today about some of the structured finance transactions that are getting done, particularly with respect to residential mortgages. Much of the lending going on with the development of new products in the residential mortgage arena are transactions getting done on the senior subordinated basis that normally in a less frothy environment would have gone strictly through a monoline environment, simply because there would not have been so much demand for a Triple B product.
We do not have a really good view as to how the senior sub market is broken out. We suspect that a lot of it is the repackaging bid, which then calls into question whether it is an investor who is really looking at risk return, or is it an investor with a slightly skewed view of risk return because they are primarily getting rewarded based upon assets under management?
In addition to the growth of the CLO market, what we might call the widely syndicated leveraged loan, the middle market CLO market, seems to have taken off, though perhaps not to the same volume as the traditional CLO. This is somewhat anecdotal, but in terms of the number of managers that we are seeing entering this space and the number of deals, there seems to be a significant level of growth. And I am not sure if that is controlled growth or the chase for yield.
IFR: In terms of new managers are there any who do not seem particularly experienced in this space?
Pridgen: Well, everyone has a resume within the space, so I do not know if there is anyone I can characterise as being inexperienced. But we tend to take a very, very narrow view of CLO experience by saying: Have you managed in a structured rated environment before? Many folks have been involved in the middle market space either because they were in a banking platform or in a hedge fund platform, or with one of the middle market lenders who traditionally had been involved. But I would say that this year there have probably been four or five platforms that have brought CDOs to market that I would characterise as being new asset managers with respect to operating in a CDO framework.
Walter Gontarek (RBC CM): If you look at the ABS space, especially the high-grade ABS space, I think that the arranger’s involvement with respect to financing the super senior tranche is an important piece of the overall execution of a transaction. I suspect that a lot of arrangers are teaming up with monolines to create negative basis packages, to hedge that super senior risk.
Pridgen: We’re definitely seeing growth in that area, and I would describe that growth both in terms of notional amounts as well as the number of funding institutions that are getting involved, and the number of banks.
You see Yankee banks who have traditionally been conduit buyers of that type of deal, who now have their name on the book, and a good part of their strategy is contacting a monoline and putting together that whole distribution on the basis of the negative basis trade back into their own conduit. You get a sense of just how much eagerness there is to get involved in that market.
Tesher: The negative basis investor has proliferated and it seems to be tightening senior price execution - you’re down to Libor +25bp at the moment. A theme that you brought up that I think we need to hash out on the corporate backed side is clearly the middle market – we have seen about a dozen actual new issuers come to market looking specifically at middle market loans as the asset class that they are seeking to incorporate into a CLO. And many of them are actually are looking at the CLO as a financing tool. That is where there is a difference with the conventional arbitrage CLO manager who is seeking to maximize the spread differential between what the underlying assets are yielding versus the respective vehicles all-in funding costs.
We’re also seeing conventional leveraged loan managers who faced with the prevailing tight spread environment, have introduced middle market buckets into their transactions to generate additional spread. And a concern that we have is that middle market is clearly different than broadly syndicated leveraged loans, and you have to have expertise in that area.
Another theme is the proliferation of second lien assets in the market - senior secured second lien leveraged loans. And the concern we have is that not all senior secured second liens are created equal. Voting rights are different for example, and second lien assets that may end up being structurally subordinate in the case of a bankruptcy.
Our concern focuses specifically on a manager’s expertise to understand second lien collateral – to understand the inter-creditor agreement and be able to maximize recoveries in a downturn on that asset class.
Pridgen: It is a very good distinction. One question is whether you are finding it difficult to get the managers to readily identify what that middle market bucket might be. One of the things that concerns us is not just that we are seeing that sort of drift into more aggressive lending areas, but it is a drift that isn’t immediately identified. So while we as an investor might say we love CLOs because I can look back at this point at close to 10 years of history as to how CLOs have performed and how leveraged loans have performed in a rated structured vehicle, if we start adding in product types that did not come from that same data source I do not know if I can take the same comfort in performance. Recovery or timing of recovery affect how different middle market loans may perform.
Tesher: Clearly the challenge on the older transactions is that the vintage CLOs in the market did not envision the proliferation of second liens and middle market loans.
In the case of the newer transactions, we are asking managers to define and establish middle market buckets and second lien buckets. The definition of a middle market and second lien loan varies. It is a challenge in terms of actually getting a specific definition of what a middle market loan is.
Clearly the CLO performance track record speaks for itself. Relative to the high yield CBOs which performed poorly in the last downturn, CLOs were resilient and performed well from a rating volatility perspective as well as from an equity perspective.
And we also agree that clearly in terms of second liens, if defaults escalate over the next two years, these assets may not fare as well from a recovery perspective, as collateralised first priority senior secured leveraged loans. And we are also trying to be specific in making sure that second lien assets are very much identified. In other words, we are putting defined second lien buckets in leveraged loan CLOs, with a corresponding low recovery rate extended for second lien loans.
IFR: Is it easy to break down second liens again – into different types of second lien loans, ones that you think have more embedded risk? Or are they all roughly comparable?
Tesher: There is a select bunch of corporate managers that have come to us and who have created defined second lien buckets in deals. And what we have said is that you can have a certain percentage of second lien assets, but over a certain threshold we’re extending unsecured to subordinate bond recovery rates because there clearly is not enough data on second liens.
Not all second liens are the same – there are strong second liens. So we don’t want to broad brush all second lien assets with the same brush.
We are basically at a point where managers are saying that you have to drill down to the inter-creditor agreement, to assess the structural issues that are in the second lien loan asset class. Specifically where are your voting rights, where do you sit in the case of a bankruptcy, etc. We are trying to standardise the definition of second lien, but we are relying on the marketplace to give us more specifics as it pertains to what that definition should be.
Kane: The key focus for the market is on this recovery rate issue. And by definition it is quite challenging to ring-fence second lien assets in a way that allows you to wrap an appropriate covenant package around that to provide definition. It ultimately comes down to a pretty precise description around strategy and intent with respect to the way managers intend to use the second lien basket. Because it is a situation where you can’t ring-fence it in a way that you can ultimately get comfortable with because of the diversity of the second lien product out there.
It is very much a case by case basis and very much a manager-dependent and skill-set- dependent situation on whether investors choose to invest or not.
Gibson: Where we are now you really have to depend on the manager and knowledge of the documents between these second lien loans and you’re paying the manager who has this expertise that most bankers and agencies do not necessarily have. Particularly in the middle market, CLO managers have been work-out specialists for years and years at banks, before you even had the leveraged loan market..
But I think the second lien buckets make a whole lot more sense than the high-yield bond buckets in prior vintage CLOs – where we had as high as 20% high-yield bond buckets. Last year about 7 percent on average of CLOs were second lien buckets. Now it’s 10% average CLO buckets. Frequency was around 40% last year, now you have 80% of the CLOs doing them. So it is an accepted thing in the market. And it makes a lot of sense because these have much better profiles to fit in a CLO – they are floating rate, they are not the high-yield bonds where you had the hedge ineffectiveness issues and so forth, where you’re paying fixed in swaps. You have the right profile as far as an interest rate risk is concerned.
And then these things spread a lot more than high yield bonds, implying that they have more risk than high yield bonds. But some of them have a lot more rights to proceeds or the assets of the liquidating company in the event of bankruptcy than in bonds.
The second liens that are issued with the first lien have different rights than ones that are done in isolation. There is no hard and fast rule. But that is what the managers are there for – that is what you are paying them to understand. So some managers get it, some do not. That is a question that investors have to ask.
Tesher: One thing we are trying to do is introduce an asset specific recovery level into our CLO methodology over the next several months. Our corporate team will provide a collateral level rating in addition to an issuer credit rating. This collateral level rating will also assess the facility and will look at the collateral package supporting a respective loan facility. In turn, second liens in most cases will be extended a different loan level rating versus senior secured first lien credit facilities. In other words, managers will be able to get the benefit of a higher recovery potentially for a true senior secured first lien loan, but they may end up having to absorb a lower recovery for something that we deem to be weak from a collateral coverage perspective.
IFR: How much is changing in terms of applying synthetic market technology to different types of CDOs this year?
Gontarek: There seems to be more and more demand for synthetic technology and synthetic buckets either for corporate risk or synthetic ABS. We’ve seen a request for a cashflow ABS transaction looking at inserting leveraged super senior tranches, which would be quite a novel way of bringing up equity returns.
To the extent that you grow that synthetic bucket more and more, the value that an arranger brings with respect to financing and underwriting the full top 80% of the capital structure is reduced. They are financing it by creating a negative basis package and buying protection from the monoline sector, and the value is somewhat reduced. I see those buckets providing some value, providing some spread. But I do not really see them becoming a significant percent of the transaction.
Pridgen: As long as equity continues to view it as their right to increase returns as much as possible, then the natural limit will come from a combination of rating agencies and what debt investors are willing to tolerate. And while I’m probably more conservative than most, I would say they are already showing a tolerance that is beyond what I would have guessed, given the available data. We have seen leveraged super seniors now for maybe six to 12 months and maybe you guys have been doing them longer under the radar screen – but for a little while, and not, say, five years.
I think folks are a little more tolerant of that risk because it is pretty remote risk and it is super senior, and it does not really look like I am going to get hurt, and my position is getting rated anyway.
You get closer and closer to what an ABS CDO might be if it is around 80% RMBS with a 20-30% synthetic bucket. I think synthetic might get pretty large, depending upon how difficult it is to get the appropriate equity returns.
Gontarek: I agree fully. The only thing I would add is that I think there is a limit to how many managers can actually manage both cash and synthetic technology to the satisfaction of investors. There is a group of managers that do cash, there is a group of managers that do synthetic, and then there is an overlap. There is a lot of growth, for sure, but to the extent that there are cash flow transactions with synthetic buckets, I think the ability to identify managers that can actually manage both types of technology is somewhat limited. And that will probably keep the growth somewhat down.
Pridgen: That sort of thing might make the investors a little less comfortable to deal with individual managers.
Llodra: I think that is an attractive element of the potential of synthetics, particularly on the ABS side, for inclusion in transactions. Because what you are effectively doing is moving to a more efficient execution of a whole bunch of residential risks, rather than 75% residential and 25% CDO, which is what you would have had to have done if you were in a cash environment. I like that trend.
There are managers that do not fall into the camp of being particularly experienced managing synthetic collateral, however I think I would rather err on that side than I would to have them pick a bunch of CLOs when they are ABS managers. I feel better about them wandering into the synthetic ABS world than I do the middle market.
Pridgen: Stick to the same asset class is your message.
Llodra: Yes because they are credit pickers. And particularly – depending on what part of the credit curve, they’re more credit pickers than they are relative value pickers anyway.
Pridgen: We start asking, well, if the asset manager is not really sourcing any more because all of the dealers are much better at putting together whatever sort of synthetics we want – and we have a credit view – then why do we need a managed deal? And am I not better off contacting one of you guys saying: ‘I have got appetite for US$1bn of Triple A RMBS exposure in single name form. I have got an issue getting comfortable and understanding single name default swap documents, but if I can do that, suddenly I am an investor who has no bid for a managed synthetic ABS trade because I just think the guy is not bringing anything except a way to take fees out.
Llodra: I think that is an excellent point. And, by the way, you can call us at any time.
Pridgen: We have a lot to figure out in the documents first, but then . . .
Llodra: I think it depends on what part of the curve you are talking about. In ABS 90% of that market is still Triple A or Double A. And I suspect there are going to be one or two transactions next year which are not managed, which are purely arranged transactions. And that will be a new challenge for the agencies to opine on that. I do not think that is the case, though, in the mezzanine space.
I think you definitely need to have managers that know that – particularly in Double B collateral, whether it be loans or ABS. You certainly need to have experienced credit people in that sector.
Pridgen: Consider what most of my colleagues do in the wrapping part of our job: We look at a lot of crossover Double B and Triple B type pools. Now, putting aside whether or not we are doing it right and whether we are smarter than the next guy, there is this institutional opinion that we are credit guys, we know what we are doing. That is why I am thinking it is less of a credit curve distinction, and more of an asset class distinction. We would not make that statement with respect to corporate risk regardless of the credit curve position. But within structured finance we think we know what we are doing, and particularly around residential mortgages and some other on-the-run asset classes it is really getting harder and harder for me as the CDO guy to argue that there’s value in a senior tranche of an ABS deal, particularly if there is a good chunk of synthetic exposure for the 8bp that somebody wants to pay me.
Llodra: I don’t disagree with that view.
Gibson: I think what is driving the demand for leveraged super seniors for both CDO vehicles and outright investors is the relative risk between that leveraged super senior and Triple A or Double A comparable non-leveraged deals. Clearly investors demand some kind of premium for this market value risk. It comes in all different kinds of flavours, and each of these leveraged super seniors are very different. But right now in the synthetic space, spreads have tightened 50% for five, seven and 10 year leveraged super seniors. And so investors’ demand has slowed down tremendously. There’s still certainly demand right there where we are, but this basis is going to change over time.
Clearly investors demand a little bit more premium for that potential market value trigger.
But the interesting thing I think is will this technology – the leveraged super senior technology, where an investor puts down, say, 10% of the full notional – be applied to cash flow CDOs?
We have seen a lot of demand as synthetic LSS notes have developed over the year, since January, and were propelled after the correlation shock in April-May. Prop desks are starting to see this as an opportunity to diversify some of the credit protection that they’re getting from monolines and reinsurers. In other words, it is another outlet for them to buy protection. They might pay 10bp to a monoline or reinsurer for the super senior tranche on an ABS CDO, but they might pay 6bp to a leveraged super senior investor. That 4bp is what they needed for compensation for their gap risk.
If they have gap risk because of this trigger it can actually result in the tranche loss being higher than the margin deposited by the investor. That is actually a significant concern for risk management departments and quants at dealers now. And that is why we are going from loss based triggers to more certain pool spread based triggers.
But if we see this technology happen in cash, then it is more infinite what the possibilities are. Clearly what has really driven the tightening is the liquidity part of the spread, the liquidity cost. And that is why prop desks have made so much money on these negative basis trades.
And whether or not you like that trade, it is a function of liquidity reasons. In 1998 it was LTCM, it was more credit contagion, it was liquidity spreads that drove out. But what could drive credit spreads out, actual credit pricing, would be, say, a 2002-like event such as when the monolines protested the restructuring clause. That would make a lot of monolines recede from the market and blow out spreads.
Llodra: There are sophisticated users saying: I am going to start a REIT and I am going to use the CDO market as my financing tool, I think that is a phenomenal statement about how far we have come from 2000 to now. And what is going to happen from 2005 to the end of the decade I think is going to be even more interesting.
Tesher: One thing that comes out of this is that the convergence of technology between cash, synthetic, and market value technologies all in one structure requires a manager to truly understand all these varied risks. It is not just purely looking at credit per se, you have to understand how you’re actually sourcing that credit now.
We have envisioned this change in the landscape. Our analysts are skilled now to handle all types of transactions. We saw that we needed to establish a platform that could handle both sets of volume.
IFR: Tracy touched upon the documentation concerns with some of the synthetic trades. Is there a possibility that people do not properly understand the documentation on synthetic ABS, for example?
Pridgen: It took us long enough just to get comfortable with cash negative basis trades and credit default swap documents. We still have the mark-to-market issue, but in terms of when we pay and what sort of liquidity issues come up, they are much closer to financial guarantees than they would otherwise have been.
With the advent of single-name documentation on ABS, the dealers did a very good job of getting together and saying: Rather than put together eight forms and send them out into the world, let’s discuss and come up with something and show it to ISDA, and make the market a little more efficient. But that has posed at least an intellectual challenge for the monolines. It is not to say there is anything wrong with the documents, it is really just to say that if you have got a set of institutions that have been doing something for 10-plus years in the structured finance space, that are now being asked to do it slightly differently, it may take a while.
The other element with respect to the documentation is the question of whether we have really worked out all the kinks. I mean documentation risk is not specific to structured finance. Every sort of legal or financial enterprise when they’re developing new documentation, you run the risk that you’ll look back two years later, there’s an event, and you sort of realize you did not anticipate that event and the docs do not really adequately describe it. Maybe some folks lose money. I think the issue around restructuring was a big issue for the monolines because they felt burned around the initial documentation for a corporate single name default swap.
So there is that component of just being cautious because there has not been enough of a track record in a real cycle to see how these documents will perform. I think the momentum is certainly that these documents will be widely implemented and without very much change.
It just becomes a bigger competitive challenge for the monolines to be able to change with it. I think it would be optimistic to think that we are going to convince the entire market to go back to some other form. Negotiations continue, but clearly a good chunk of the market sees value, they are executing on that basis, and they will keep pushing forward to the extent they can.
Gontarek: I think one of the interesting things with documentation risk is the interplay of documentation risk and product innovation and the speed at which new products are coming out. Leveraged super seniors have probably been around for about nine months. That meant that traders, and structurers, and marketers, and clients, and rating agencies have hammered out confirmations for these LSS trades in less than a year. And in LSS we probably can all agree there are various dimensions to talk about for the first time.
First of all, what is the loss trigger or spread trigger? Who calculates it? Is it an option to de-lever the trade or not? Or is it an obligation? There are a lot of moving parts here that really have to be hammered out. The good news, I think, is that in the LSS space what has happened essentially is that the more senior part of the synthetic capital structure, which was the domain of monolines and structured credit vehicles, has been opened up to new market players. And essentially there were barriers to entry for hedge funds. And a lot of commercial banks did not care about tranches paying 5bp. And now they are paying 50bp they are good relative value over the plain vanilla single tranche Triple A.
So what is happening essentially is that these barriers are down and new players are coming in and taking the risks. We have seen hedge funds and commercial banks, in Europe for sure, and certainly SIVs and structured vehicles that have the monolines’ background of an adequate understanding of documentation.
IFR: How much has actually been sold in the LSS format, and how much of a pick up in demand was seen after the events of April/May?
Gontarek: I think the volume has just been absolutely tremendous. The thing that that research maybe does not actually catch is the size of the trades, the deltas and the risks associated with hedging those is actually quite a significant amount of risk being passed around the system on the back of something greater than 199 trades.
IFR: Is that working smoothly in terms of bank offsetting? Are all the banks trying to put these trades together at the same time and are all the banks going into it?
Gontarek: I think it is bifurcated. There are folks that that don’t do LSS, others that do it with market triggers, and there are folks that do it with loss triggers and spread triggers.
Gibson: The obvious first thing is the tranche mark to market trigger, because there’s no basis risk there for the dealer, they know exactly what they’re dealing with on pricing.
And then you started seeing investor valuation concerns because there is a little bit of a conflict of interest there, particularly if the dealer is the valuation agent for the tranche value. So investors wanted pool spreads because there is a lot less chance you are going to have disagreement or conflict of interest about that value – because you have Markit Partners and other data providers with independent marks for individual CDS names.
That was when the agencies really got into bed with us as far as modeling. It was a challenge to model what the mark-to-market of the pool spread would do to the economics of the transaction, but they were very fast in adapting their models to that. But investors quickly said, okay, what about loss-based triggers? In the pool spread trigger matrix they saw loss by time to maturity. So why not just have a pure loss-based trigger? And so that is what we saw a ton of demand for in the last three months globally.
But there was a lot of uncertainty about where that trigger should be struck, even if they were striking it more tightly there was still uncertainty. So essentially what has happened is a lot of US based dealers have gone back to the pool spread type triggers because of that uncertainty. But in Europe you’re seeing still a lot of loss based trades.
Gontarek: I think people are trying to manage the gap risk of high loss triggers. The challenge I think we all share is in rating mark to market transactions. A lot of investors do want to see the rating. They do take a lot of comfort from that. So the challenge is really finding an opportunity where rating agencies, investors and arrangers can align themselves on LSS basis.
IFR: You touched on dealers providing valuation. Are there expectations of people wanting different types of valuation? Are people happy with what they get from dealers?
Kane: We generally view the valuation process as a customer service exercise. And by and large we try to provide the type of valuation that an investor asks us to provide, whether it is a mark to market valuation or a mark to model based valuation. Each investor seemingly has a different need or a different use of valuations. It is pretty diverse. It is not easy to categorize whether people are happy, because they are quite diverse in their needs in terms of what the valuations are used for.
IFR: Is there there any role for boutiques or independent firms in secondary structured finance trading?
Gibson: Spreads are so tight and the credit environment is so benign right now there is not a whole lot of opportunity in secondary. But when spreads blow out again, there will be a lot more boutiques, a lot more opportunity, a lot more trading.
Tesher: I wonder what happens if some of the treasury areas at the funding banks that are obtaining the credit default swaps on the negative basis side decide to seek alternative areas to deploy their capital.
Pridgen: The way we at FGIC view the world, we are the negative basis trade investor. There’s the guy that lends me money, but I’m the one who goes home with the risk. So if we leave the market, or if the other monolines and protection sellers leave the market, or even just show some level of discipline and really back up pricing, pricing will probably back up in the near term pretty sharply, because the vast majority of Yankee banks that are funding these positions call up a couple of protection sellers, whether it is a monoline or a reinsurer, and they get it done with relatively tight pricing. In the near term if we all back away that will probably push back pricing.
I don’t predict it happening because you are just not going to get that level of pricing discipline across five or six or more protection sellers.
One potential or perhaps more likely scenario is you have a number of banking regulatory changes that say to Yankee banks and others that the relative advantage of holding a Triple A position with a hedge starts to go away. And it starts to make the Yankee bank ask why am I paying this guy hundreds of thousands of dollars to do something that I can do just buying directly onto my balance sheet?
That I think may have the negative basis trade funder start to leave that market. But I do not think it creates a really painful backup in pricing.
Gontarek: If you put it in perspective, 10 years ago you had Yankee banks coming to the States to lend money to corporates, falling over themselves to try to lend money to corporates and finding it really tough, and using pricing as the mechanism to do that. Now using a balance sheet to buy Triple A risk that is above another Triple A tranche, maybe wrapping it and getting further Triple A protection, is a pretty high quality risk to begin with. One, it does not require lots of bricks and mortar. So you’re right, it may be an expense, but not relative to making loans and knocking on doors.
IFR: We have been talking about financial market technicals. Is this going to continue to outweigh fundamental credit in terms of determining spreads? What sort of credit jolt would change that?
Pridgen: It’s really hard for me to see what level of credit disruption - given how efficient the market has become to finding different levels of appetite for risk – would really upset the applecart. You touched upon the dislocation in the correlation trading market – and dislocation may be a strong word. There was pricing movement and some folks were long risk they did not want to be long. But it seemed to be a fairly healthy environment, where folks moved in pretty quickly and took risks that priced out a little bit. I don’t know if I would really call that a disruption, even though it was two of the most significant corporate names in the US.
Gontarek: I think a lot of bank prop desks and hedge funds would call it disruption.
Pridgen: I think that was healthy. What I would call a disruption is when people leave the market. When suddenly there is no price that is good enough.
Gontarek: Sure. I am certainly not suggesting there was a wholesale exit. But I think there were gapping crises, and I think what has come out of it is possibly two good things. Number one is a lot more focus on risk management. Lang has already mentioned how a lot of risk management quants are looking at LSS structures and where triggers are set, and whether they should be set, and what type of triggers. But even risk managers looking at a correlation book is good – and is the balance of placement across the capital structure even or uneven? I think that became a critical issue in May.
And secondly I think it drives innovation. I think the whole discussion about LSS was fuelled by the desire to place risk above and below the 3-7% mezzanine tranche. And then there is a lot of innovation now fueling CPPI product for private banks, for retail, and for other investors. So, you are right, in that context it is not dislocation. It is fueling innovation and it is resulting in risk managers going back and altering assumptions. It could become a quite healthy thing.
Pridgen: And so it is hard to see going forward any moderate credit events that may be on the horizon having the impact on the CDO market that we saw in 1999 and 2000. I mean as an investor and as a senior investor that would normally disproportionately benefit from that sort of widening, I would like to say I see that on the horizon, but we do not. What we see is more competition from non-traditional protection providers, and a relatively benign credit environment. And I think it is a real challenge for us.
Gibson: The whole correlation shakeout in April-May meant dealers had to focus more on their risk management. But what they had not been doing is keeping up with the hedging of all the bespoke activity they had been doing the prior two years. And so that resulted in two things. There was the hedge fund correlation unwind trade that got a lot of attention immediately, but in the next ensuing few months after that period it became clear that dealers were hedging bespoke activity a lot more than they did before. They were selling protection on mezzanine tranches, which matched exactly the attachment profiles of the bespoke deals that they had put together; and then hedging out the entire capital structure more. It was mostly in equity where they were doing this – where they were buying protection on equity to hedge the full correlation in their books.
And that shifted relative value across the entire capital structure, it shifted value to equity and to the super senior. That super senior value is coming back out again. So it has resulted in implied correlations going from 18-20% pre-May to about 10% average currently. It has resulted in a fundamental shift. And what is going to disrupt that is a new technical – some kind of hiccup like what happened with the fundamental idiosyncratic risk event that got dealers to shift things.
If the economy turns south, then we are going to see a whole different alignment of value of cost of capital structure and wider spreads. Calling that is well nigh impossible. There are very few signs of when the credit cycle is going to turn right now. We are looking at energy prices more than anything else as kind of a determinant. But that is our only real clue at the moment.
IFR: CPPI has been a major innovation for CDOs in Europe this year. Do you expect that to be applicable in the US?
Gontarek: In Europe investors for a while used CPPI technology in fund products or in other asset classes. And that has now migrated to the credit space. The product is regularly shown out on a static portfolio basis or on a managed basis. There have been a variety of managed synthetics, where the CPPI technology is used, and even long-short CPPI, so there has been quite a bit of innovation there.
The volume of business in that space is small compared to the volume of mezzanine business that was done for the last several years.
Kane: I think the whole CPPI product innovation has a lot to do with the fact that globally investors are chasing yield, globally investors are looking for alternatives to invest in. And instead of jumping in with their eyes wide shut in a direct, fully levered investment without any sort of principal production, there clearly is a subset of demand that is interested in trying to add incremental yield to portfolios, but would rather do that in a principal protected format.
I agree that it tends to be mostly non-US counterparties that are interested in investing in these types of products. But the overall interest in structured credit is such that I think you will see more and more of these CPPI type structures applied to a pretty wide range of asset classes, and potentially delivered on a truly global basis.
IFR: Let’s conclude by asking everyone what excites you most about the market in the coming couple of years.
Gontarek: Structured credit retail trades. And I’m not talking about private banking, high net worth individuals – I’m talking about real retail at the branch level, in denominations of five thousand or 10 thousand.
One of the challenges I think that I always have when talking with people about it is you see stock prices and interest rates and people debate whether it is too high, or too low. But really does the man on the street know where implied correlation is? How about CDS prices? So clearly there is not the level of transparency with respect to the underlying instrument, and the various risk measurements. That is one challenge I think that we really have to start to be hugely sensitive to. And that I think increases the reputational risk of institutions, whether they be arrangers or managers involved in the space.
That’s point one. Having said that, a lot of countries actually do not have a broad spectrum of yield enhancement product to invest in to begin with. So they’ve been buying a lot of the same thing. In Canada where investors bought the same Canadian telecom names five years ago, was that a good thing from a diversification perspective? I don’t know.
So in some ways for structured credit products going into these markets, whether it is with a CPPI package or not, actually presents itself as an adequate and quite satisfactory alternative to investing more and more in Nortel, for example, which is closer to home.
I think the issues are disclosure. I certainly am not satisfied with the level of disclosure that I’ve seen across the board around the world. My firm does not believe in blind pool synthetic CDO transactions with retail investors. It is just a rule. You have to tell people what the underlying risks are, and underlying names in the transactions if you are dealing at the retail level. That’s one rule we have. And number two is risk disclosure issues. We go to people that are not dealing with the product everyday, but maybe are support members of the team – and say do you understand what we are really selling here? Do you understand some of the risk measurements? And have them look at the prospectus.
And another thing is liquidity. We think it is very important to have liquidity in structured product when you are dealing with retail. We have tried and often been able to list it on the stock exchange. So there have been dealers that have been identified that have to make and will make small markets in the secondary market on the product. That’s one. Two, we provided quarterly or annual windows where a product can be put back to us at an NAV or at a mark to market redemption price. So the whole issue could come back. It shouldn’t happen, but it could. So again we give people the opportunity to exit.
And lastly there is education.
Llodra: For retail distribution at Bank of America, the threshold for which we are sourcing interest is very significant in terms of net worth. For a lot of the reasons that Walter pointed out, I think it is offering liquidity and what form you offer it in that is important. Marking those positions I think is a continual struggle. How you do that – is it mark to model, is it some NAV based approach? And having that disclosed upfront and agreed upon is important. And then visibility of how my investment is doing relative to how I thought it was going to do – how we work that out and who interfaces with communication to what can be a very complicated process. I think it is something that institutions must focus on as well.
We would love to see equity distribution globally, as well as in our institution, down to the retail level expand. I think there are applications where it makes a lot of sense. What scares me a little bit is there are clearly applications where it does not. And what happens when that occurs? Because I think that is going to be a very visible event if it does occur.
Kane: I think the clear trend right now is a convergence trend amongst all types of investors, regardless of what type of investor they are, pension plans, insurance companies, banks, endowments, foundations, across the board – that have historically had a lot of other options.
What I think is going to create options for us is going to be the creation and delivery of products into a wider set of investors, given the shortage of available options to invest in other markets. And we need to use structuring responsibly, leverage responsibly, and partnership with the rating agencies on CPPI or whatever the case may be.
We are really sitting in the centre of a lot of different markets, a lot of different investors, a lot of different asset opportunities, where I think the options available to all of us to work on interesting things and create interesting products are going to continue to expand before they contract.
Gibson: It is interesting to think about what would happen if spreads blew out like they did in 2000 or even 1998. For the first six months there would be a lot less issuance, until pricing is reset, investors get a little bit more comfortable, and the initial uncertainty of whatever blew spreads out dissipates. Then what you might see is some assets that had gone too tight from a trading standpoint to fit in the CDOs, like some of the non-mortgage ABS sectors, like autos, and cards, and student loans might all of a sudden be getting securitized again.
But what I do not think you will see is high-yield bonds becoming attractive again, no matter how far spreads go out. There is always going to be a niche asset class, particularly in synthetics, where the application makes sense. But you are never going to see half the market be high-yield CDOs or even a quarter. There is not enough to make the arbitrage work in those deals, there is not enough spread, or not enough subordination to really match up to the kind of collateral or default volatility we have had in that sector.
I think during the three years of a prolonged bull market, we have already pretty much securitised any asset that makes sense from a CDO standpoint. I mean there are some things that we try like hedge funds and private equity that are always going to be a niche asset class. And I think we have had a chance to try everything. So there are not going to be a whole lot of new types of CDO or collateral types that are securitised in CDOs.
IFR: Will the synthetic ABS space rival corporate synthetics?
Gibson: I think it will not be as large as corporate CDS because you do not have the natural protection buying that you do in corporate CDS. The interesting thing is we have seen the interest rate derivatives market evolve in 10 years, from soup to nuts. Corporate credit derivatives evolved in five years. I think what we are seeing in ABS CDS is a 2.5 year timeframe. And we are about a year or a year and a half into that timeframe now.
But there are limits – not enough protection buyers, as you have in corporates, but also you have referenced particular bonds. In corporate CDS we already have more trading than we do outstanding bonds. In ABS you can’t go really beyond that, or you can, but you keep referencing the same bond over and over again. At some point that gets kind of foolish. And it is a little different than the fungible corporate credit risk.
Tesher: Right now we are operating in a relatively benign credit environment. And if you look out 12-24 months, many people think that if credit starts to deteriorate, where would we be? Regardless, in the near term, we will continue to be operating in an environment where there is still scarcity of collateral.
As such, we see a continuing expansion of the single name credit default swap market on the ABS side. The concept will be integrated more in the context of the structured finance CDOs.
Also, given the renewed focus on middle market loans, we envision seeing greater inclusion of unrated assets which need to be extended a credit opinion via our credit estimate process.
Also, in the structured finance sector, commercial real estate has basically found a new form of execution via the CDO. Many of the issuers in this space are using the CDO product as a financing tool, as opposed to arbitrage motivation. We are going to see this trend continue along with more unrated assets being sought to be included in these vehicles. From a rating agency perspective, we are going to have to gear-up in anticipation of having to provide credit estimates for a greater level of unrated collateral going into CDO structures in general.
Not withstanding strong interest in traditional cash and synthetic deals, we are seeing convergence of cash, synthetic and market value technology. Hybrid transactions will flourish.
One thing that we are going to see probably from our perspective at one point is a resurgence of distressed debt deals.
If a credit downturn does occur, we envision collateral managers and hedge funds will consider stressed and distressed obligations. They’re today trying to create this flexibility in transactions in anticipation of spreads widening out. So we will probably see more transactions over the next year having larger buckets for distressed assets.
We are also going to see more and more cash and market value trades looking to long and short credit exposure within their structures.
Pridgen: I do expect to see continued innovation in the form of sourcing investors. We talked a little bit about retail I think, certainly the folks on the bankers’ side probably feel they span the globe looking for investors. And I think that will likely continue. Where it will matter most to someone who sits where I sit is the degree of new synthetic investors coming in to the space, really just creating more competition and more pricing pressure for senior risk, whether it is directly synthetic or whether it can somehow be funded by another party and then separately placed with some of these new participants synthetically. So I think for those on the liability side that bodes well for continued tight pricing.