US CDO Roundtable 2005: Participants

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.

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