The phenomenal growth of the CDO market has lead to new structures, with investors moving away from the initial black box CDOs toward transparent ones, initially static and most recently dynamic, with substitution or a manager. This article addresses some of the more recent developments in the sector and the analytical challenges they present. Although we are aware there are a lot more issues that need to be reviewed by investors in every individual situation, space restraints have meant we have focused on the most important areas.
Static & Dynamic CDOs
The key differential in synthetic CDOs, as with their cash counterparts, is whether they are static or dynamic. We doubt the investor debate as to which one is superior will ever be satisfactorily resolved, given the pros and cons of both. However, the direction the market seems to be taking is to find ways to mitigate the downside of each of the two structures.
Hence, the key questions an investor should ask is not whether the pool of referenced obligations is static or dynamic, but rather:
1 Who selects the reference obligations?
2 Who has the right to change one or more of them,
when and how?
All kinds of variations are possible:
* The reference pool may be selected by the CDO equity
investor, arranger or manager. In any case, there is some
ground for moral hazard due to the possibly diverging
interests of these parties.
The case where the CDO equity investor or manager selects reference obligations is the classic case of moral hazard demonstrated in many cash CDOs and motivated by reward. The ways to reduce this risk are outlined below.
* Either the CDO investor or the manager may be allowed to
replace names in the portfolio under certain conditions and
according to pre-determined eligibility criteria. In fact, in
some cases the role of the manager may be assumed by the
CDO arranger or credit-default swap counterparty, but may
result in the selection of the cheapest to include names. The
ability to make changes in the portfolio can vary from broad
to increasingly restricted, the latter being more widely used
recently.
* The manager's ability to trade may be limited or tied to a
certain percentage of the reference pool. It can also be
limited with criteria, such as only selling impaired credits.
Investors should consider this range of options to be inversely proportional to their confidence in the manager, and related to the quality of the reference pool and their investment objectives. A wider discretion in trading is probably more appropriate for high-yield portfolios and more experienced managers.
* The ability of the manager to change the portfolio and to
what degree also depends on the investment strategy. The
range can be wide in terms of market sectors and
investment strategies.
In any individual case, it is a balance between flexibility granted to the manager and the complexity of the deal.
The manager's ability to trade may be limited to 'credit improvement trades' (linked to spread tightening beyond certain predetermined levels, premium ratios and other tests) or 'credit deterioration trades' (risk of a credit event occurring as assessed by the manager).
Furthermore, trading may be executed either by termination or offsetting exposures. In fact, different transactions can be differentiated by the level of prescription of the use of termination and/or offsetting trades. For example, the deal structure may allow the manager to choose one of the above actions. Or, alternatively, it may direct the manager to:
* pursue a termination in case of an improved credit, thus
generating cash into the structure,
* pursue an off-setting trade in the case of a deteriorated
credit, which does not require any cash outflow from the
structure, contrary to the termination of a deteriorated credit.
Cash & Synthetic Pool
In the early CDOs the term synthetic referred to the method, in which the credit risk of the reference pool was transferred. More recently, the question of cash or synthetic is equally applicable to the way the exposures are created:
* Synthetic: selling protection on given names via credit-default
swaps; buying protection is also possible in some cases.
* Cash: buying exposure to given names in the form of bond
purchases (short-selling of bonds has not been allowed, to
our knowledge),
* Hybrid: a combination of the above.
To these two broad categories of assets, one can also add total rate of return swaps and bi-variate risk positions, which we believe will be of limited use in future deals.
In this regard, we believe the key question is not so much how the reference pool is created, but rather:
1 What is its credit quality?
2 What level of diversification can be achieved and maintained?
Given that credit-default swaps exist primarily on investment grade corporates, in order to improve the diversification of a default swap pool, cash bonds are a welcome addition. In fact, cash exposures can take several forms, including bonds, asset-backed securities and stripped convertibles.
ABS, in its broadest meaning, can add diversification that is not easily available through credit derivatives or other cash alternatives. Such sectors include consumer loan portfolios as in the traditional ABS/RMBS, corporate portfolios on name, where default swaps are scarce or non-existent, such as high-yield debt, mezzanine loans and SME bank loans. Such a portfolio should benefit from broader defensive diversification and higher rating stability. Recent studies of rating transitions emphasise the difference in transition ratios and in spread volatility for ABS and corporates under the same economic conditions of duress experienced in the last few years, this can be viewed as evidence of lower correlations between the two sectors.
In addition, a hybrid managed CDO allows the manager to explore relative value opportunities that may emerge between default swaps and cash assets to achieve better returns through more efficient leverage. Overall, a hybrid structure should allow for the optimization of asset allocation given the CDO manager's skills and sector knowledge.
However, investors should not forget that regardless of how a given deal is structured it is mainly about credit. A portfolio of credits--cash bonds or reference entities--require similar analysis in terms of credit quality, diversity, single credit exposure, total spread, default and recovery expectations, etc. But, the way one arrives at them may require somewhat different analysis.
Liquidity
In a typical cash CDO structure, given the pass-through nature of the cash flows emanating from the asset pool and directed to servicing the CDO liabilities, liquidity is usually needed to cover temporary cash flow shortfalls usually due to timing mismatches. In a synthetic CDO structure and especially managed synthetic CDOs, particular needs for liquidity may arise. So instead of an assumption that there is a liquidity facility in the deal, the questions instead should be:
1 Is there a need for a liquidity facility in a given synthetic
CDO structure?
2 How is the liquidity facility sized and procured?
Particular need for liquidity in a synthetic CDO are created by:
* shorting credit-default swaps,
* trading losses that are crystallized by termination,
* credit events requiring cash settlement or bond delivery.
Furthermore, liquidity may play an active part in the execution of portfolio management strategy and specifically asset allocation changes.
In certain trading strategies, for example uncovered shorts, the liquidity needs may be substantial and can be satisfied only through a dedicated liquidity facility. The size and costs of such facilities are of key importance, as high liquidity costs may reduce the benefits of some savings achieved on the liability side of the synthetic CDO through low cost super-senior tranche hedging.
Another aspect of liquidity management is the shortfall of classes B and C interest payments. A potential solution is introducing pikeable interest (fully or partially capitalized interest) for these classes in the form of the capitalization of the missed interest for two consecutive periods for the single A rated tranche and indefinitely for the BBB rated tranche.
This week's Learning Curve was written by Alexander Batchvarov, managing director and Jenna Collins, v.p., in international structured credit research at Merrill Lynch in London.
