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| Jeffrey Gundlach |
Gundlach is president and heads a 40-member team responsible for TCW's mortgage-backed and asset-backed portfolio. Overall, the team runs $37 billion in assets, including $11 billion in structured products. Gundlach is based in Los Angeles.
The last few years have been bullish but are there any factors that could slow down the market?
You always have cycles. If you go into an increased default cycle, then of course you would see a downward credit migration, particularly if you saw weakness in the housing sector, which would lead to increased defaults. That's one factor you can look to that ultimately has to happen. There are cycles and one day, there will be a negative housing cycle. When that happens, the quality will go down and issuance will slow down. It has to be a macroeconomic event. From time to time, there's been fraud, but that doesn't destabilize the market. It's the macroeconomic event that could cause the most problems.
The other thing that can slow down is spreads. If spreads get too small, then you get to the point where deals cannot get done and that would curtail demand. This doesn't necessarily cause a disaster for existing CDOs, but on a mark to market basis the assets would have to reflect a spread widening.
Why has there been such explosive demand for CDOs?
It runs side by side with the growth of hedge funds and all kinds of alternative investments. It all has to do with the perceived low returns available. Take a look at stocks. The one-three- and five-year return numbers on indexes are smaller than they are for bonds. So there's no return being generated there, even now as we're retesting highs on the Dow Jones Industrial Average. We live in a world where investors are hoping for a return above inflation and a premium, with pension plans looking at actuarial assumptions where they need 8-9%. You're not going to get that out of stocks or bonds, so it leads to alternatives and that connotes to the CDO market.
For example, if 90% of a CDO gets [funding at] LIBOR plus a small fraction, the hope for a 10-12% return on the equity has been realized in many cases and it's been a good experience. Will it continue? It depends on rates, defaults and the yield curve. A flatter yield curve also eats into the likely yield curve. As long as there are low returns in the traditional investment landscape, you're going to have a robust alternative market and a robust CDO market.
How has the investor base changed?
What's amazing is it seems traditional, even public pension plans are considering CDOs. It started out to be a fairly esoteric kind of thing. I personally have had discussions with public pension plans that have thought about getting involved in diversified pools of CDOs and CDO equity. Five or six years ago, that never would have happened. A lot of people are still skeptical, they think it is just another derivative type of thing that adds complexity and cost. While there is no doubt there is added complexity and the cost of underwriting fees, there is the ability to deliver exposure to asset classes on a diversified basis that is very difficult for most people to gain themselves. And it is tradable, even if the liquidity is not fantastic.
What's your take on the growth of the secondary market?
It's still a little fledgling. I actually ran a secondary CDO fund from 1999 to 2004 and in those days, there was a huge liquidity haircut to sell a secondary CDO. Typically people sell because they are nervous with the performance, so it tends to be a distressed market, which means it will never be a highly liquid market. There is some trading and most desks probably do trade most days, but it is not a high volume market. But distress would be a catalyst for increased market volume.
What are the main types of CDOs out there and what are TCW's plans for the year?
There are high-yield CDOs, bank loan CLOs, emerging market [backed deals], and you have ABS deals, especially ones using mezzanine credit. We have a full calendar and we think we will close eight ABS/MBS deals this year.
What is different about the CDO business these days?
There's been an awfully big growth in the CDO business. Five years ago, a rating agency such as Standard & Poor's had something like six people in its CDO group. Now, they have 100. Most of the banks have a CDO sales force now--there's this whole new division that's been put in place on Wall Street that wasn't there five years ago. Five or six years ago, the CDO team was sort of a satellite that was viewed almost with some curiosity. Now they are real divisions and are hiring sales people whose job is to sell primary and secondary CDOs. These groups are not huge but they are in place and growing. These days you see a commitment in terms of staffing on Wall Street and at the rating agencies and you see most household names doing CDOs. It's gone from a curiosity at the fringe to being more mainstream, though it will never been as mainstream as Treasuries and S&P 500 equities.
How do you select underwriters for vehicles you manage?
We have a series of businesses and generally a certain series may have been with a certain underwriter. If we are happy with their performance and the relationship, we will likely continue the relationship. But we also want to be diversified, so when we start a new line, we might be inclined to start with a new underwriter. There are a lot of underwriters that want to do this sort of business. We've done deals with many underwriters and we like it that way.
Any other thoughts on the outlook for the market?
It continues to evolve at a fairly rapid pace. Synthetics have overtaken cash in corporate-credit backed areas and may grow significantly in other areas, too. That will be interesting to watch. Also, deal volume is very high and I think it will continue to be.