Lehman Brothers has closed the first managed cash flow, collateralized debt obligation with loan-only credit default swap contracts as the underlying assets and is getting ready to close another. Some players in the LCDS market said the deal, managed by Airlie, is the first of its kind. The bank has also completed three static portfolios. An official declined to comment about the portfolio that has not yet closed.
Termed LCDO by the bank, the product has a 70% fixed recovery and behaves and is structured like a traditional cash flow transaction that has tests and triggers including over-collateralization tests and interest coverage tests. The bank is selling the entire capital structure rather than doing a bespoke trade or a single tranche trade. It has a bullet maturity and the LCDS is non-callable. Lisa Watkinson, head of global structured credit business development, said there has been several billion of LCDS traded in conjunction with these deals.
Airlie, a Greenwich, Conn.-based hedge fund, is the manager of the $400 million portfolio, called AIRLIE LCDO I (AVIV LCDO 2006-3). It is the third structure in the AVIV series and the first done with a manager. It is anticipated that more managed deals will be coming, primarily done by hedge funds, although at least one CLO manager is getting ready to do one. A call to an Airlie official was not returned.
Lehman started marketing the first in the series, AVIV I, a static portfolio, in August and closed it Sept. 7. AVIV II is also static and closed in October. While each deal has its own marketing period, the portfolio can be ramped up in a day as compared to months for traditional collateralized loan obligations, which is why the turnaround time on these deals is pretty quick. It completed Pebble Creek LCDO 2006-1 in November. While the AVIV series is a five-year trade, Pebble Creek is a seven-year program. The decision to move to the longer time frame was made because seven-year spreads were better on a relative basis than five-year spreads.
Lehman started by doing Exum Ridge CBO 2006-1, a CDO with CDS as its underlying assets. The firm has done five structures in this vein, completing the first in February. Other banks have done similar deals, but many in the market have not heard of another managed deal like Airlie. "We have been seeing them the last three to six months," said Yuri Yoshizawa, group managing director and co-head of U.S. derivatives at Moody's Investors Service, about the static LCDS portfolios. "What we have started seeing is the advent of synthetic transactions that include loans as reference obligations, but they vary in terms of the way they work."
"We started with the Exum Ridge program; a cash flow CDO that referenced high-yield CDS as the assets," said Jason Schechter, global head of cash CDO trading. "From there we went to doing deals referencing LCDS contracts, which is a natural progression."
What is next for the product is unclear, but Watkinson explained that in a tight spread environment "we all have to continue to be creative and innovative." It is anticipated that with the launch of the index product, LCDX, expected in the first quarter of next year, the volume of LCDS will increase. "This is going to be an important part of the market," she said. "It will be more important when we launch LCDX and start to do tranches."
