Syndication pros say selling subordinated tranches of collateralized debt obligations has become more challenging recently as insurance companies, historically the primary investors in the tranches, have become more cautious in the wake of increased volatility and new accounting standards. Bankers say triple-B and double-B tranches on deals have become a challenging part of filling out the capital structure on CDOs, much like the equity piece. Filling the void -- for now -- are managers of CDOs of CDOs that are buying new issues and impaired assets in the secondary market from insurers looking for a way out.
"There's a declining buyer base. Now investors have to look at potential impairment positions and mark down portfolios and after Sept. 11 they are reevaluating everything again," said one CDO syndication banker. Tom Swank, chief investment officer at Security Benefit Life Insurance, explained that his company, invests in triple-A CDO tranches. "We like to play the higher-tier tranches and we like plenty of subordination." But Swank noted that FASB accounting rule 99-20, a requirement passed this past April, has prompted insurance companies and other CDO investors to rethink investment strategies. Swank says, accounting rule 99-20 requires insurance companies to look forward and discount cash flows if present value is less than originally expected.
Martin Rosenblatt, director of securization services at Deloitte & Touche, said investors of CDO paper must now write down the current fair value of assets on their income statements if the current fair value is less than what is on the company's books or if present value of estimated future cash flow on the assets has decreased since last measured. "Some [companies] are more leery of these tranches now because of potential volatility," added Swank.
In addition to insurance companies shying away from subordinated debt tranches, equity tranches are also subject to new accounting rules, continuing to make equity a tough sell on deals. "It's a tough credit market and 99-20 exacerbates this because you have to recognize it on your books," said Scott Hartz, v.p. and portfolio manager at John Hancock, an investor in senior debt and equity tranches of CDOs. According to Hartz, Hancock has invested modestly in equity tranches over the years and has had some write downs and due to the recent credit environment is, "re-evaulating buying equity positions right now."
Picking up the slack of insurers are managers of CDOs of CDOs, who can buy impaired triple-B credits, combine them with stronger performing assets, and issue a new set of liabilities. The new liabilities are once again sold to an investor base similar in profile to the original deal. Arturo Cefuentes, managing director at Triton Partners, a firm that closed a CDO of CDOs a few weeks ago, explains that his shop was able to ramp up its deal with triple-B paper available on new CDO deals as well as available paper in the secondary market as a CDO of CDOs typically uses triple-B assets as the majority of its collateral. "As more insurance companies sell assets, we can buy these assets and use them for collateral for our next deal. Then we issue a new set of liabilities and often re-jigger the structure to sell debt and an equity piece," he says.
But that support may not be able to last indefinitely, said Brian McManus, CDO analyst at Merrill Lynch, explaining there is uncertainity about investor appetite for tranches of CDOs of CDOs. "CDOs have given a lot of support to the market, but we don't know how robust support will be in the future," he said. The typical return on a CDO of CDOs is lower than a traditional high-yield CDO--at its highest 18% versus 40%--but, risk is reduced.