Certain CDO investors stand accused of not fully understanding the products they are buying. At what could be a pivotal point in the credit cycle, the explosive growth in this sector and higher degrees of leverage raises some important questions both for these investors and for the health of the wider financial system. By David Bentley.
The search for yield after an 18-month period of significant spread-tightening across all subsets of the CDO universe has prompted more and more complicated structures. Meanwhile, surging demand for structured credit products, significantly from many investors that are new to the sector, has sparked fears that some are getting in over their heads, while the concentration of associated credit derivative risk is giving regulators plenty of food for thought.
“Portfolio drift, leverage and investor understanding are all relevant topics for CDO investors,” said Mark Adams, head of CDOs at Dominion Bond Rating Service. “These vehicles are levered, and the distribution of returns for investors have limited upside and a large potential downside.”
Concerns over the risks in CDOs came to greater prominence amid the recent wobbles in the credit market – and in particular the auto sector. S&P downgraded Ford and GM and their related finance companies to junk status, catching out a number of hedge funds involved in positive-carry default swap trades, where they were long equity on index tranches and short on the mezzanine. The impact on synthetic CDOs ratings, meanwhile, was watched carefully, given the wide degree these credits are referenced, particularly in the European market.
Despite GM and Ford being referenced in more than 80% of European CDOs, their concentration is relatively small, S&P pointed out, with more than 100 names in the average portfolio. Of the 745 rated CDO tranches referencing Ford and/or GM entities, only 10 (1.3%) will be downgraded – and only by a single notch – while 27 (3.6%) required placement on CreditWatch with negative implications.
There could be more downgrades to come, but S&P expects these deals to recover, provided there are no more credit problems. “The market has responded well,” said Simon Collingridge, managing director at S&P, pointing to bigger portfolio sizes and the recognition of the impact that a single default can have.
“Many synthetic CDOs are now managed, whereas in the old days they were just static, so managers have the ability to substitute names. Additionally, deals have decent amounts of cushioning when they are rated, and there is greater transparency as rating agency models have been made available. CDOs of ABS are also more popular now and these have more stable underlying ratings.”
Not all ratings are the same, however, and there can be a big difference in the required level of credit enhancement from S&P and Fitch when compared with more conservative models from Moody’s and DBRS. These differences can be more pronounced when looking at higher levered, or “CDO squared” transactions, where overlapping names can have a large impact on performance.
“We use a higher default curve for non investment-grade entities, use higher correlations and look at how volatile a deal will be over time,” said Adams from DBRS. “With autos, we assume high correlation with auto part manufacturers and finance arms, and because we have higher credit enhancement, auto exposure is not a problem for us.”
Adams added that he did not expect any downgrades on the 35-40 CDOs covered with exposure to the sector. Fitch, meanwhile, said negative credit migration in the automotive sector is unlikely to lead directly to CDO downgrades. It did, however, point to potential credit events called on credit default swaps of non investment-grade automotive parts suppliers. These would be more vulnerable than auto companies which retain substantial degrees of liquidity. The expected corporate restructuring between Ford and Visteon, which it spun off in June 2000, could trigger a restructuring credit event, Fitch said.
“Ford and GM are very big names and rating actions do get attention, but for CDOs we have no more concern for them than for the other 400 names that are widely referenced,” said Ken Gill from Fitch Ratings. “CDOs are more sensitive to credit events than rating migration on individual names. It isn’t that we are not concerned about the auto names, but more about the particular knock-on effects from the rating migration of particular names.”
Synthetics see selling
Market reaction has been mixed, with spreads on lower levered cash CDOs holding firm, while investment-grade synthetic deals widened by up to 5%, depending up on the portfolio. "Managed IG synthetics are seeing spread-widening across the rating spectrum, from Triple A to mezzanine," said Ben Graves, analyst in JP Morgan's CDO research team in New York. "So far, this widening has been limited to investment-grade corporate deals, and the contagion has not yet spread to structured finance CDOs and CLOs."
This widening was apparent first in the secondary market, which JP Morgan said was no real surprise, with slower issuance and volatility making it difficult to draw too many conclusions on new issue spreads from primary. The weakness was limited to a widening of some 5bp–20bp over a two week period, which has now stabilised but was enough to prompt a downgrade by the bank – to underweight for Triple As and neutral for mezzanine tranches of investment-grade CDOs.
“This spread-widening has been the first to take place anywhere in the CDO market for the last 18 months, and the outlook now is for wide spreads on seasoned bonds – which will have relatively higher GM/Ford concentrations – while newer deals will have limits on high-yield bonds and bonds with wide spreads,” said Graves.
Wider spreads could themselves pose more risk for CDO spreads – by prompting additional supply as previously unworkable arbitrage slots back into place. "Significant widening in the underlying CDS indices makes new managed investment-grade synthetics more viable. We expect to see increased issuance as many deals are waiting in the wings and spreads could be pressured."
Further bouts of profit-taking could also follow and weigh on spreads, although this will be limited by the amount of senior CDO paper tied up in negative basis trades – which accounts for some 80% of the market. “As investors re-assess the risks in the market, there is potential for some selling at the Triple A level – either as a defensive move or profit-taking," added Graves. “At the Triple A level there is more paper outstanding, so it may be difficult for the secondary market to absorb it."
The more severe losses in structured credit index trades –which could be as much as 30% on some holdings – caused a rush by highly levered hedge funds to liquidate positions, bringing back memories of the LTCM collapse in 1998. Profit-taking on CDOs that have performed well is anticipated to offset losses on tranched index trades and also provides a timely reminder of how much models depend on certain assumptions. If everyone’s model makes the wrong assumptions then it might not be too long before the collapse in correlation feeds into synthetic CDO structures.
“Hedge funds are levered vehicles themselves and are taking a very levered position on credit risk,” said Jireh Wong, senior vice president at DBRS’s CDO group. “When volatility comes along, everybody’s pricing models no longer work. You then get an unwinding of positions and more of a liquidity crunch.”
Some investors have questioned S&P’s view that the European synthetic CDO market has passed its most widespread test to date, given that we have only seen two relatively modest downgrades and not a default which would provide more of a test to leveraged structures.
“I think it is a bit premature to say the market has passed its stiffest test to date,” said one investor. “The market has not been properly tested in a downturn yet.”
“We are clearly in a relatively benign part of the cycle regarding default rates,” commented another UK-based investor. “Downgrades increase the WARF of cashflow deals, but defaults really have the impact on OC tests – and it is the OC triggers that ratings agencies look at when deciding to issue a downgrade.”
The Parmalat default in late 2003 gave the CDO market a pretty tough workout, but with its impact restricted to less than 20% of synthetic CDOs, downgrades were not particularly widespread and were limited to one or two notches. The credit downturn of 2000-02, when there was a high level of fallen angels and defaults, provides further parallels. The mere presence of Enron or WorldCom then would have led to a downgrade, but these days structures have higher degrees of leverage.
“We are seeing that the CDO market has surely matured; however, the underlying environment is still pretty benign, compared with late 2002, when there was a significant number of downgrades," said S&P’s Collingridge. "Furthermore, during that period, there was not a huge difference in the number of corporate downgrades and the number of CDO downgrades."
“I agree that 2000 to 2002 was a bad credit cycle, but on the other hand I don’t think that rating agencies should be predicting future credit cycles,” said DBRS’s Adams. “Who is to say that the next credit cycle won’t be worse?”
Data from S&P’s global ratings transition survey shows the link between CDO and corporate rating actions, with CDOs seeing an annual downgrade rate of 14.8% in 2002 compared with 14.9% for corporates. In 2003, 9.9% of CDOs were downgraded compared with 9.2% of corporates, while last year the CDO downgrade rate was 3% compared with 4.1% for corporates.
The agency’s global speculative-grade default rate provides a pretty good indication of where we are in the current cycle, and although defaults are likely to increase, the picture is quite soothing. At the end of April it was 1.64%, compared with an eight-year low of 1.47% in March and the long-term average of 4.91%.
A complicated business
Two high profile legal cases, where banks have claimed they were not properly explained the risks involved in CDOs that they were sold, have stoked the debate on whether investors and regulators have been able to keep up with the pace of innovation in this market.
Barclays Capital settled out of court with HSH Nordbank over losses in CDOs it sold to the German bank in 2000, while Bank of America faces a similar claim from Italy’s Banca Popolara di Intra. Michael Gibson, head of trading risk analysis at the US Federal Reserve, recently highlighted an institutional investor survey which suggests a minority of up to 10% of investors do not fully understand what they are getting into with CDOs.
“I would agree with the comments from the Federal Reserve that there is a small percentage of people who do not understand the risks,” said one seasoned structured finance investor. “Investors should be asking for models on defaults, recoveries and the timing of defaults, but there are lots of investors that wouldn’t ask for that. If a sleepy Southern European bank wants to buy €50m from a deal without asking anything, then the investment bank is not going to tell them that they haven’t asked the right questions. These are the investors who are going to have trouble going forward.”
He went on to say that a manager’s reputation is more important than an attractive structure, and the proliferation of managed deals has made things more comfortable for investors. Disclosure is still required and investors need information on portfolio composition, deal documentation and ongoing reporting. Investors these days get plenty of documents to go through, but do they read it all and do they understand everything?
"There is generally far greater transparency in the market and the synthetic market has evolved to be on a par with cash," said Fritz Thomas, head of Deutsche Bank's European CDO business. "We have been very focused on providing an appropriate level of transparency to investors in our CDOs both pre and post-close. While this focus is not new, it has been particularly important of late as the growth in popularity of structured credit has brought new investors into the market."
Another investor pointed to possible misunderstandings in popular synthetic CDO squared structures, using the traditional split of 80% Triple A ABS and 20% CDOs. “This is a gimmick for ratings stability and mark-to-market,” the investor said. “To some investors these can look very safe – with 80% in secure consumer backed Triple A ABS and 20% in the more risky inner CDOs, Clearly all the risks in these deals are in the CDO squared portion, but some investors are turning a blind eye.”
Fixed recovery rates often of 90% are pretty standard on the ABS, while the probability of default on consumer ABS is low.
As well as seeing break-evens run for the life of the transaction, the investor said additional requests would include seeing the portfolio sliced and diced in different ways to see where the skews are, rather than just looking at the average rating.
“Just like with derivatives in the 1990s, even sophisticated investors can lose a lot of money, and the product gets the blame,” said DBRS’s Adams. “CDO products can differ in true risk, and some are so high up the capital structure than many non-CDO structures are more risky.”