The next generation of collateralized debt obligation repackagings is in the pipeline and could hit the market in the coming months, according to sell-side and rating agency officials. Bankers are said to be discussing the possible sales of CDOs that will be made up of underlying "CDO squared" paper--bonds constructed from CDOs. The new product is tentatively being labeled a CDO cubed. "There is some preliminary buzz about this, but I have not heard of any specific deals," says one CDO sell-sider. Another adds that bankers are merely at the stage of proposing potential structures to rating agencies.
The innovation comes as the CDO squared market has begun to season since they were first issued a couple years ago, and the overall number of such deals increase. Richard Gugliada, managing director and head of the global CDO group at Standard & Poor's, says the rating agency has rated roughly a dozen CDO squared transactions. He confirms it is looking at CDO cubed deals but declines to be more specific.
Outsiders speculate banks would presumably repackage CDO squared paper into new deals to shed some of the warehouse risk they may have incurred by holding paper they have been unable to sell in the current CDO environment, given the marked slowdown in CDO sales this year. But, given that only a dozen or so deals have been done, some market pros question whether there is enough outstanding paper to structure a diverse cubed deal. One official at a veteran CDO manager scoffs at the entire notion. "There's a limited universe out there; there's absolutely not enough diversity," he says. Others note that because CDOs tend to pool riskier securities, selling mezzanine tranches of a cubed deal could prove difficult. "If the underlying paper is mezzanine, that would be a hard sell. Mezzanine cubed is a lot of risk," says one researcher.
Still, because CDO paper tends to trade a lot wider than the securities underlying it--because of structural opacity and less liquidity--experts say there is value in repackaging it. Dan Castro, head of structured finance research at Merrill Lynch, notes that triple-A structured finance CDOs trade at LIBOR plus the low- to mid-60s, while triple-A home equity paper is about 30 basis point tighter. The gap is even wider for credit card and auto paper. Castro says he has not heard of any CDO cubed plans.
One CDO collateral manager says spreads wouldn't be enough to tempt him to do a CDO cubed. He agrees there's not enough CDO squared paper out there, and says recent performance trends have shown that CDO technology does not spread out risk as well as it should. He says: "Diversifying is harder than we all thought, and I'm not sure the maturity [of CDO squareds] is there yet. I would think it would be difficult to accomplish."