Structured credit has hit troubled times since August. Billions of dollars of CDOs have been downgraded nearly every week, with some tranches going from triple-A to junk in a single action. Warehouse facilities have been shut down. In the US, most investment banks’ CDO heads have resigned or been sacked. Yet away from CDOs of ABS, deals are still being done and new structures devised to cope with changed conditions. Tessa Wilkie reports on the new opportunities the crunch has kicked up.
Once lauded as the cutting edge of financial innovation, and for revolutionising the way risk is held, structured credit is in the doghouse. This once gleaming market is now condemned for being too complex and too illiquid to value properly.
Shareholders and regulators fret about where the risk actually lies. An outsider to the markets could be forgiven for thinking that all CDOs were synonymous with subprime.
There certainly is some reason for the gloom.
Banks have disclosed tens of billions of dollars of writedowns due to US CDO of ABS exposures. Surprisingly, they have taken the most pain from the most senior part of the structures. They have gone through tricky calculations to estimate their exposure to subprime MBS through these debt instruments, sometimes only to increase the writedown a few weeks later.
Warehoused assets have been stranded on banks’ balance sheets, prompting banks to push deals into the market just to get rid of them.
Many CDOs of ABS have defaulted — 33 according to Standard & Poor’s last count, with Fitch predicting many more — and UBS’s Series 103 Tyger notes became the first constant proportion debt obligation (CPDO) to go bust in late November, costing investors over 90% of their principal.
Yet all the screaming headlines and desperate shedding of risk have produced significant opportunities for investors, provided they have the cash to take advantage. That’s a big ‘if’ at the moment.
"There is great value across the capital structure," says Miguel Ramos, managing partner of Washington Square Investment Management in London. "The market is broken. Before there was a large pile of money which has now disappeared, so there is a massive mismatch. We’ve had sellers just say: ‘Name a price’."
LBOs win in flight to quality
There has been a well publicised flight to quality in the structured credit markets. Issuance since September has been slight, with just over 10 deals priced.
Simple leveraged loan CLOs have predominated, from top tier managers like Harbourmaster Capital, Intermediate Capital Group and Mizuho Investment Management (the exception being newcomer Permira).
Spreads ballooned to the 55bp-70bp area for triple-As, from an average of 21bp at the beginning of the year.
Preplacement is the norm, and notes are often issued at a discount, though this is not always disclosed. Preplacing paper could just be a way of dealing with the warehousing risk. It is easier for an investment bank to place one class of notes with an investor early, even if it has to pay up — at least it knows the notes will get sold.
This is what happened to Permira’s triple-A class, issued to one investor at par in August, before the deal was finally priced in mid-November.
Leveraged loan CLOs remain popular with investors and managers, but the big question is where in the structure investors see most value.
"We are overweight CLOs right across the capital structure. The best value is in double-As and single-As, because there we see the best structural protection for your spread," says Siobhan Pettit, head of structured credit strategy at Royal Bank of Scotland in London.
Neil Servis, managing director in fixed income at Morgan Stanley in London, finds mezzanine and second lien collateral more attractive, as value and sensible structures are returning.
"We are focussing on the bottom part of the capital structure, avoiding leverage," says Ramos. "We target 23%-24% return, based on our assumptions. We don’t want to try leveraged triple-As, even if the assets have strong underlying quality. There is limited availability of leverage and historically we have been negative on mismatched funding structures."
Fresh kinds of collateral
Market participants are also looking away from the CLO for opportunities. Pettit thinks they will be found in new asset classes, including some outside credit. Investors will favour more liquid underlying collateral, as it might give them a more liquid CDO.
"Financial institution spreads are very wide so there’s quite a lot of juice there to put into a CDO," she says. "Investors are reasonably comfortable with financials’ debt. That sort of trade is going up in credit quality from some of the previous underlying asset classes and also getting the juice."
Pettit expects commodities and foreign exchange to be used in small quantities.
However, actually getting a deal off the ground will still be difficult. The investor base has shrunk, and demand for notes has dropped. The triple-As are particularly hard to place.
"The problem is not the equity investors, but finding debt investors," says Ramos. "If you’re a good manager and find the right asset classes, equity investors will be interested. However, there is not a willingness to buy the super-senior. This is because investors need to rethink their strategy, where they messed up."
Ramos says banks are in the best position to buy triple-As, as under Basle II their risk weightings will be low, and at the moment buyers can pick up a spread of 70bp-75bp.
The new triple-A spreads, however, may suck too much yield out of the structure to make the lower tranches worth bothering with.
"Primary cashflow CLOs really depend on the execution [i.e. pricing] levels for the triple-As, which is the most difficult part of the structure at the moment as clearing levels are very high," says Marcus Klug, managing director at Omicron Investment Managers in Vienna. "It’s difficult to achieve the equity returns investors are looking for."
‘You can’t do that with cash’
A possible way out of trying to find triple-A investors at economical spreads is to structure synthetic deals.
"With synthetics you don’t have to fully distribute the capital structure," says Brian Yelvington, senior macro strategist at CreditSights in New York. "Equity and mezzanine [CDO] holders have always been pretty comfortable with the default risk, and they understand the mark-to-market sensitivity of these inherently leveraged instruments. They’re always going to be there at some price point.
"You’re going to see a lot fewer ratings-constrained investors at the top of the capital structure, now that they’re realising ratings volatility. But with synthetics I can issue the equity without issuing the triple-A. You can’t do that with cash."
Synthetic CLOs take days, rather than months, to ramp up. This is an attractive feature for banks stung by warehoused assets over the past few months.
Pettit is also a fan: "Synthetic investments fared much better through transparency of valuation," she says. "You also had options: if you didn’t like your valuation you could unwind your position and get out. It will prove interesting how investors react when they’ve totally digested where they took pain."
Pettit predicts that cash structures will be derivativised — replaced with synthetic solutions — as well as an increasing use of macroeconomic overlays, such as adding an interest rate or FX hedge overlay to a deal based on credit risk.
Yelvington agrees, but sees synthetic structures as more applicable to creating balance sheet CDOs than arbitrage deals.
Several synthetic CLOs of leveraged loans are in the market, and Morgan Stanley priced a $500m deal for Carlyle Group early in December. But this is small compared to the number of CLOs that have been priced since September. Why are more deals not being produced?
Synthetics have problems of their own. "Synthetics are definitely more volatile," says Yelvington. "The reason is that until credit default swaps came about it was near impossible to short anything. In a fast moving market, I may not be able to sell my bonds but I can lift [i.e. buy] CDS protection. This is because they’re standardised. We don’t have to worry about idiosyncrasies."
These are intensely complex structures, which may scare some investors off.
For banks, correlation risk is a particular worry, although Pettit remains confident.
"Banks made losses in synthetics because they chose not to hedge, particularly on the super-senior, because it [i.e. super-senior valuations] had been flat for so long — but not because their models failed," she says. "The correlation market has had two tests, one this summer and the other in May 2005. The market has been getting more mature and the more it weathers, the better it gets."
Liquidity scarce in LCDS
In the loan market there is also a higher basis risk between CDS and the cash asset — a result of the market’s youth.
"Unlike investment grade corporates where a relationship between a swapped bond and a single name CDS is very tight, in loans that relationship is often 80bp-100bp wide," says Yelvington.
In the US, there is a more developed group of arbitrageurs in the LCDS market, eager to buy protection on loans and earn that basis spread.
Liquidity is also an issue for loan CDS in Europe, compared to the US. Most market participants agree that the launch of the LCDX index tranches in the new year will help this. Some remain to be fully convinced, though.
"The LCDX market should improve liquidity, however most CLO managers won’t be able to use LCDX tranches, as short positions are typically not allowed in CLOs," says Klug.
There are more opportunities out there than just issuing deals, however. One option for investment banks is to use their expertise to help others clean up their subprime mess.
Mizuho is reportedly marketing repackaging services for holders of CDOs of ABS, and Pettit thinks repackaging and restructuring will be keeping structured credit desks busy well into next year.
"These restructurings will take the form of mark-to-market solutions, mark-to-market wraps," she says. "A lot of the stuff on banks’ balance sheets is Basle II-inefficient. Restructuring will partly involve reoptimising capital at risk and capital weighting."
Whether in simple leveraged loan CLOs or increasingly funky collateralised swap obligations, the market presents a wealth of opportunities — for players that have preserved their resources and reputations.
Players that haven’t should perhaps give Mizuho a call.
"There are certainly some investors that are becoming more positive on the markets and have liquidity," says Servis at Morgan Stanley. "Where the value is depends on where you sit."
