US CDO Roundtable 2005
It has been a year of good problems for the CDO market. Demand for structured credit products remains extremely strong, despite stubbornly low spreads. This has led to difficulty in sourcing assets to place in cash CDOs, though the continuing sharp growth in deal volumes for cash trades is testament to the way that arrangers and managers have diversified in the structured finance, real estate and middle market loan sectors.
Cash CDO creators have also continued to import synthetic market techniques to keep deals flowing.
The correlation market disruption of April and May that followed the downgrades of Ford and GM seemed set to drive both investors and dealers from the synthetic market, and possibly cause fear of all forms of structured credit.
Instead a number of hedge funds and bank proprietary dealers simply soaked up their trading losses, without the withdrawal of a single major player.
Tranche prices corrected and a new market – the leveraged super senior sector – exploded to life, in a demonstration of the adaptability of both structurers and investors.
The participants at IFR’s recent New York CDO roundtable anticipate further growth in the sector next year, but do not underestimate the challenges they face in terms of sourcing collateral and differentiating their deals.
Some concern was expressed at potential future strains from the current market expansion.
New managers are moving into the market, while some existing managers are straying from their original areas of expertise in the search for new forms of collateral.
It is far from clear that all managers understand the potential ramifications of securing deals on second lien loans, for example.
There is also much work still to be done on recovery rates for different asset classes.
The synthetic market continues to throw up potential problems as it expands to meet unfulfilled demand. Synthetic buckets are sometimes added to cash deals by managers with little derivatives market experience. And the rush to create a synthetic ABS CDO market meant that standard documentation had to be agreed at breakneck pace, and some users, such as monoline insurers, remain unconvinced by the language of the new ABS default swap contracts.
Demand for leveraged super senior deals also created an element of “ready, fire, aim” in terms of structuring by arrangers. Some deals have spread triggers, others are loss-based, and there are valuation and hedging issues surrounding this that are being addressed as deals price.
The roundtable participants also looked forward to further structuring of CDOs for retail investors, though here there was awareness that potential problems have to be addressed well in advance of a deal structuring.
The liquidity and valuation issues that remain unresolved for professional CDO investors and structurers may look like a series of lawsuits and regulatory crackdowns waiting to happen, for deals sold to retail.
But secured credit trades are certainly no more inherently risky than the equity basket deals that are pitched to retail buyers every day.
Barring any spread blow-out, 2006 could see CDOs finally take their place in the retail product toolkit.