Firms in the U.S., including Deutsche Bank, Lehman Brothers and JPMorgan, are developing synthetic collateralized debt obligations referenced to CDOs in a trend that is likely to double the size of the market, said officials at these firms. Increased volumes in the CDO secondary market as well as wide spreads, may be encouraging the move, according to David Schwartz, CDO researcher at Morgan Stanley in New York. Nik Khakee, director in structured finance at Standard & Poor's in New York, said S&P has traditionally rated around two such deals a year, but predicts that number may double this year.
Alex Reyfman, credit derivatives strategist at Goldman Sachs in New York, however, predicts that not all of the planned CDOs of CDOs will be fully sold because there is not enough investor appetite.
The amount of CDO paper trading in the secondary market has exploded over recent months and wide spreads means there are arbitrage opportunities, leading to the flurry of CDO of CDOs structuring. Investors reducing their CDO portfolios are responsible for much of the activity, according to Reyfman. This, combined with synthetic CDO tranches trading at significant discounts in the secondary market, may be encouraging managers to buy the products and repackage them as CDOs of CDOs, he said. While it is difficult to generalize, Reyfman estimated that downgraded tranches initially rated AAA and AA may be trading at 60-70% of par in the secondary market, while those referenced to portfolios which have experienced defaults may trade as low as 20-30%.
Dean Aotani, managing director and global head of CDO structuring at Deutsche Bank in New York, said the firm offers both cash and synthetic CDOs of CDOs. Synthetic CDOs can be advantageous because the arbitrage in the senior tranches of CDOs of CDOs is heavily driven by funding costs, and synthetic CDOs allow investors to segregate funding and risk transfer. Eileen Murphy, global head of CDOs at Barclays Capital, added that cash CDOs of CDOs, on the other hand, are generally more transparent than synthetic structures. Barclays is considering launching cash and synthetic CDO of CDOs in its third-party business.
