Managing director, lead portfolio manager of collateralized debt obligations and director of fixed-income research at State Street Research & Management. The Boston-based subsidiary of Metlife closed one asset-backed securities CDO last year--the $400 million Fort Point transaction.
Spreads have widened on the secondary CDO market. In these conditions, what is the appeal for primary market CDO buyers?
There is indeed a discrepancy in spreads. But in my view, it's not so much 'new' versus 'old' as it is 'good collateral' versus 'not so good' or 'damaged collateral.'
If you use your CDO like a kitchen sink and don't put in the best collateral, your deal will trade at wider spreads both in the primary and secondary markets. I think the market is smart and prices efficiently. For instance, a single-A tranche for an ABS CDO or investment-grade CDO with clean collateral will trade in the mid-100 basis points over LIBOR on primary issuance. But if the collateral is slightly damaged, it can trade as wide as 250-400 basis points over LIBOR on the secondary market.
How is your Fort Point CDO deal performing so far?
The over-collateralization test has improved. But it takes a couple of years before rating agencies give you credit for this with an upgrade. [Fort Point closed in October, which is considered too early by several market participants for a performance judgement].
Some collateral managers complain that indentures in general are too restrictive and do not allow them to manage properly. What is your opinion on this?
It is true that rating agencies tend sometimes to put irrational clauses in a deal. In reality, you can't dictate risk management by rules. At the end of the day, the very same rules put in the indenture to benefit the deal may end up hurting it.
Most of the time, rating agencies try to fix an abusive practice. But, what is abusive in 1% of the cases may also be good practice 99% of the time.
Do you have an example?
They require you to hedge a fixed-rate security over the entire life of the vehicle. If I buy a four-year fixed-rate security and reinvest four years from now into another four-year fixed, what I really need is a four-year hedge. But, rating agencies won't allow me to do that. They will expect me to put on an eight-year hedge from the beginning. What they should do is allow the manager to hedge asset by asset.
It's like locking your kids in the house and closing the doors because you're afraid they might run away. But then, there's a fire and your kids cannot get out. By being too stringent, rating agencies may give managers the message that it's no longer worth doing a managed deal and that you should only do static deals because you can't do anything.
Do you subscribe to the common CDO market view that a CDO manager's challenge is to balance the interests of both the debt and the equity holders? And how do you achieve this balancing act?
It's not a balancing act. Take care of the collateral and everyone--note holders and equity holders--will get paid. But it's true that some managers out there play the window dressing game. The collateral starts to deteriorate. One strategy used by these managers is to sell a bond at par and buy two assets at 50 cents on a dollar, pretending they have twice as much protection. What they do is maximize the equity return by buying cheaper assets to increase excess spread.
The equity gets paid faster and the bondholders are left out of the loop. It's called building par or fooling the rating agencies. We're not in the business of manipulating rating agencies.
What's your macro outlook for the CDO market this year?
Same trends as last year. Collateralized loan obligations, multi-sector and synthetic structures will remain the three main sub-sectors. The scarcity of ABS collateral should stop a lot of managers from doing deals this year. But you won't see a slowdown in issuance because synthetic deals look like they are being printed.
You have one single-tranche synthetic with $1 billion worth of underlying collateral issuing only a $15 million triple-B tranche. Derivative numbers are based on the $1 billion notional. Bonuses are paid on that.
You are still relatively new in this market. What if your deals turn sour in the future? What strategy will you employ?
First, ABS CDOs deals, unlike corporate CDOs, get less risky as they age, because they de-leverage. If you have the right people and the analytics for surveillance, there is plenty of time to trade out of a security and buy one that is improving. But some managers don't do that. They keep the deteriorating collateral, as long as they get paid, we don't. Essentially, what you have to do is monitor the cash flow. So in keeping with this we run default stress scenarios. We use credit-driven cash-flow class analysis. We have four people devoting their entire time to surveillance.
Tell us about your buying strategy. What do you like? What do you stay away from?
Manufactured housing and aircraft are not so good. We are extremely cautious with those sectors. Our last deal had a 1% bucket of manufactured housing but it was a triple-A rated tranche from Vanderbilt, which the market views as the best issuer. Same for aircraft. We had a 1% allocation to Enhanced Equipment Trust Certificates, but we chose Delta Airlines, not US Air or United. Franchise loans are risky too. We have only a 1% bucket of it. We like commercial mortgage-backed securities best because as an asset class it's entirely protected against pre-payment risk and because in a slow economy, leases tend to be long term. Fort Point had a 20% bucket of CMBS collateral.
How is your CDO team organized and what are your goals for this year?
The CDO business is handled as part of our structured finance group, totaling nine people. We manage $9 billion in structured finance assets, allocating $4.8 billion to residential mortgage-backed securities and REITs, $2.5 billion to CMBS and $1.7 billion to ABS.
We have two dedicated traders and two portfolio managers and the rest of the staff focuses on research. In terms of deals, we currently have our second ABS CDO cash flow deal in the works. We plan on closing a synthetic ABS CDO by year-end.