In the early days of synthetic collateralized debt obligations, most deals were static. When static deals were hit by a series of defaults in 2001 and 2002, managed deals became popular with investors. Indeed, synthetic structures offer great flexibility to managers to trade in or out of names in the reference portfolio. This Learning Curve asks the following questions: If investors expect managers will add value through trading, does it make sense to restrict the trading flexibility with portfolio guidelines? When are restrictions on trading flexibility beneficial to investors? How should we measure the degree of alignment between the manager and the investors? Before answering these questions, let's first define trading flexibility.
For the purpose of this Learning Curve, trading flexibility is defined as the level of discretion that the manager has when making substitutions. The manager's level of discretion refers to:
* substituting reference entities, perhaps subject to portfolio guidelines linked to rating methodologies, or having no ability to substitute reference entities;
* substituting impaired credits freely or not. Impaired credits are credits the manager expects to significantly decline in credit quality. Often deals are structured so that the manager can remove impaired credits without having to pass rating agency tests;
* being subject or not to a trading volume limit. Under such limits, the manager can trade a maximum percentage per year--generally 20%--of the reference portfolio;
* withdrawing or monetizing surplus credit enhancement. The surplus credit enhancement is measured as the cushion above the level of enhancement consistent with a certain rating. This cushion makes the rating of the notes more resilient to adverse credit events in the portfolio; and
* the right to obtain quotes or trade with dealers other than the arranging bank. This feature enables the manager to obtain better execution on its substitutions.
Full Trading Flexibility: Beneficial For Investors?
A reasonable assumption is that trading flexibility is beneficial for investors when the transaction has an incentive structure that aligns the economic interest of the manager with the performance of the rated notes.
Therefore, the higher the alignment of interest, the higher the managers' trading flexibility would be. For managers with a high alignment of interest, full trading flexibility may make sense at the inception of the transaction. Conversely, for managers with a low alignment of interest, we would normally expect to see trading flexibility restricted by the terms of the transaction.
If it turns out that a manager with a high alignment of interest performs poorly, then the assumption that full trading flexibility is beneficial for investors may no longer hold true. For instance, Fitch would expect to see that full trading flexibility be restricted after a two-notch downgrade from the original rating. In the event of a downgrade by five notches or more, trading flexibility will be further restricted. These dynamic restrictions will be defined in the initial terms of the transaction.
In summary, to determine the appropriate level of trading flexibility, investors need to measure how their interests are aligned with the manager and also assess the quality and performance of the manager.
Measuring Alignment Of Interest
For many managers, considerations about their reputation impose a significant conservative bias on their decision-making. Nevertheless, the way a manager in a synthetic CDO is incentivized may also be an important influence on management strategy.
Incentive structures tend to be transparent in synthetic CDOs. In these transactions, the manager's relationship tends to be defined by contractual fee arrangements. There is often no concept of a manager holding an interest in the performance of the equity, for example.
While incentive structures may be transparent in a synthetic CDO, they may also be complex. Managers of synthetic CDOs may benefit from fixed and variable fees, and how the manager behaves may be affected by the details of such arrangements. For example, where a manager gains financially from trading gains, or from monetizing surplus credit enhancement, a bias may be introduced into the manager's decision-making toward taking higher risk credit decisions. This may be the case particularly where trading gains can be realized on an ongoing basis rather than at the end of a transaction after the rated notes of the CDO have been repaid.
The important issues are:
* Does the manager benefit from trading gains or monetizing surplus credit enhancement;
* The size of the variable fees in relation to the fixed fees; and
* Can variable fees be withdrawn prior to the maturity of the CDO?
The highest alignment of interest is when the manager is also the investor, i.e. self-managed deals. The lowest alignment of interest is when the manager is the protection buyer. This is the case when a bank's correlation trading desk manages a CDO under which it is also the protection buyer. Between these two extremes, there is a spectrum of alignment of interest (see table).
The alignment assessment will in practice be influenced by a number of complex factors and it is not possible to incorporate all these into a simple table. For example, if rating stability is important to investors, this can be achieved through a specific incentive structure where the manager will receive a performance fee only if the rating is maintained or improved. In addition, if a manager was able to withdraw a bonus during the life of a transaction but the withdrawal depended on there being significant surplus credit enhancement above that required to maintain the original rating, then an assessment of a high alignment may be possible.
Assessing A Manager's Quality, Performance
It is important that a CDO manager has some expertise and experience of managing CDOs.
For instance, as part of the operational review of the manager, Fitch obtains information specifically on: the experience and expertise that the company and staff have in managing and trading credit derivatives, supporting resources and IT infrastructure used, trading strategies and capabilities employed, counterparty and market risk management, selection and monitoring of the synthetic portfolio, and operational synthetic CDO administration processes. Fitch also publishes specific CDO Asset Manager ratings.
Regarding the performance of the asset managers, the rating evolution of the CDO tranches under their management is the most obvious indicator. Another interesting indicator is the maintenance of the surplus credit enhancement, that is the cushion" above the level of enhancement consistent with the original rating.
In summary, the appropriate level of trading flexibility in synthetic CDOs depends on:
* the alignment of the interest a manager has with the CDO investors, and
* the quality and performance of the manager.
For a more detailed discussion on this issue please see Fitch special report, Consultation on Managers' Trading Flexibility in Synthetic CDOs, published Jan. 9.
This week's Learning Curve was written byAlexandre Linden, CFA and director,Lars Jebjerg, director, andManuel Arrive, CFA and associate director in European structured finance atFitch Ratingsin London.