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Managers Climb CDO Ladder From Equity To Take Mezzanine Risk

Asset managers of synthetic collateralized debt obligations are increasingly taking on mezzanine exposure in their own deals to pacify CDO investors and lead managers seeking to forge a more explicit alignment of interests between asset managers and their product as notes take over from equity as the hardest part to sell. Canadian giants RBC Capital Markets and CIBC World Markets are both independently in talks with third-party managers with a view to creating their respective first externally managed synthetic CDOs globally, said officials. In both cases the manager will be expected to buy mezzanine tranches, they added.

BNP Paribas, meanwhile, installed a requirement late last year that managers buy mezzanine tranches when requested to do so by investors, said an official familiar with the firm's strategy. The firm is readying launch of its first publicly rated CDO, dubbed Craigie Street, under this system, he noted.

A lot of investors have figured out that if they are buying tranches at the AA level and the manager is buying equity, they have very different incentives, noted one official. David Allan, managing director, head of the Canadian securitization group and head of the global synthetic credit structuring group at CIBC in Toronto, explained that if equity pieces are priced sufficiently widely, the yield can effectively offset risk. Mezzanine tranches represent the real risks in the transaction, he said.

One official at a U.S. tier-one manager noted that demands that managers buy mezzanine pieces is reminiscent of requests that managers take equity slices of their own deals in order to reassure investors. Typically these requests have been made to non tier-one managers, he noted. Many established managers argue against the requirement, believing that their reputation as a manager speaks louder than any financial participation in their products, he noted.

RBC is in talks with several third-party managers, with a view to offering several managed CDOs, said Robert Shi, director in structured credit trading in New York. The firm already offers static CDOs as well as CDOs of CDOs.

CIBC, which already manages its own balance sheet CDOs, is on the hunt for third-party managers, said Allan. CIBC is developing a CDO sized at around CAD600-700 million (USD412-480 million), which will reference a pool of Canadian asset-backed securities or corporate loans or bonds, he said. The degree of mezzanine the manager takes will depend on the breadth of its mandate, with a manager with a large responsibility for the product likely buying as much the entire BBB tranche, he said.

Craigie Street, meanwhile, has been structured so that TCW Asset Management, the CDO's manager, would buy mezzanine pieces if investors so demanded, said the official. Because of TCW's strong reputation, however, this will not be required, he said.

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