Collateralized debt obligation sales pros will have to come up with new ways to market CDOs to equity tranche investors after structurers have had to alter the way they divert excess spread between the tranches in stressed conditions. David Tesher, managing director at Standard & Poor's in New York, explained that in a negative credit cycle, haircuts in newer vintages of CDOs will result in the spread paid to equity investors being shut down more quickly than has been the case in older deals. CDO issuers need to develop ways to have equity investors accept the possibility of such a shutdown, while at the same time showing investors they may not necessarily lose out over the life of the deal, he said.
The new mechanisms have come about because rating agencies have changed the way they value secondary market products. Previously they would have accepted the par value of an asset even if it was trading at lower levels when the manager bought it. The mechanisms include purchase discounts, additional coverage tests and haircuts on 'CCC' rated assets, Tesher explained.
Previously, many CDO managers purchased distressed credits they would not ordinarily have found attractive, as a means of building up the par value of assets to pass overcollateralization tests. The new rules means this no longer works. This practice negatively impacted the performance of the deals. Trapped excess spread in new deals is either reinvested or used to pay down senior or mezzanine tranches, with the view that this activity will better enhance the performance of the portfolio.
If equity investors are aware of the possibility that distributions may be shut down in the short-term they are less likely to be aggravated by the move, said Tesher. This move should align the interests of the debt and equity investors.
Jean Fleischhacker, senior managing director at Bear Stearns, however argued that the proliferation of new haircuts places too many constraints on deal managers and hurts all CDO investors by making it harder to complete full structure deals. Instead of placing such restrictions it would be better to look at a manager's track record and give them flexibility to manage the deal if the track record is attractive, she said.