A sharper focus

A need for more information on collateralized debt obligations has been evident since last year when the market witnessed a record number of downgrades. Hardeep Dhillon reports on the moves being made to demystify the product

Toxic. Explosive. Opaque. These are just some of the words used over the past few years to describe collateralized debt obligations. One word that has not featured frequently but that many market participants are now trying to add to that list is transparent.

US private placement regulations have contributed to the lack of transparency in the collateralized debt obligation (CDO) market by not requiring public disclosure of information on transactions. This has shrouded the market in a cloak of secrecy, creating problems for investors in truly understanding the product, which in turn has caused problems with liquidity.

“There was always a transparency issue,” says Thomas Marx, CDO strategist at Goldman Sachs. “And the question was how to enhance liquidity when you did not have much information to work with.”

The lack of information has meant that trading volumes have been hard to come by because of the secretive nature of the CDO market. Though some banks have come up with ‘guestimates’ of the size of the market, a definitive number is still proving to be elusive. Nevertheless, according to the BMA, the CDO market has escalated from $1.2 billion in 1995 to $246.5 billion in the second quarter of 2003 and is one of the fastest growing segments of the fixed-income market.

A further barrier to transparency lies in the unusual structure of the instrument. Because each and every CDO is structured according to unique criteria, no single CDO is like another. This diversity across the asset class makes it difficult for investors to get to grips with the product. For Mark Moffat, head of European CDOs at Bear Stearns in London, the key to the market’s development is to get investors more comfortable with CDO transactions. CDO investors are recognizing that they can no longer merely rely on rating agency analyses or simple static models. It is imperative that they understand the individual credits in their deals, as well as the particulars of each deal structure, in order to assess each deal’s return and risk potential.

The Bond Market Association (BMA) is looking to address this problem with the launch of its online CDO Transaction Library this month. The library will contain information on specific CDO transactions, which has previously been unavailable to those outside that transaction.

This resource will enable qualified institutional investors and investment banks to access deal documents, transaction swap agreements, offering memoranda, indenture documents, and monthly trustee reports. Currently only 144A transactions will be posted on the site, but Regulation S deals are expected to follow after certain legal hurdles have been overcome.

“The goal is to bring efficiency, transparency, and liquidity to the secondary market by making transaction documents available to dealers and to qualified investors,” says Nadine Cancell, vice president and assistant general counsel at the BMA.

Confidence

In order to build a secondary market, trading desks must be willing to make bids on bonds. But to do so, banks need to feel comfortable about what they are buying and the risks involved. By providing the transaction documents to trading desks, banks will be able to model the deal themselves and feel confident about making bids on the bonds. “The more firms you have making bids, the more robust your market is,” adds Cancell.

As for the investor community, the transaction library will aim to provide a single access point for all the different transactions by all the different dealers. The data from the library will allow investors to model deals too. “That should help the development of the market,” says Cancell. “Once the deals are up there [on the website], you will see a big difference in the liquidity and efficiency in the secondary market.”

Another driver toward greater CDO market transparency is Intex Solutions’ analytics platform. Intex provides an extensive database of deal models, data, and analytics, covering over 10,000 structured securities. San Francisco-based Wall Street Analytics provides a similar service to qualified investors, but only on about 350 deals.

Jim Wilner, vice president of Intex in Needham, Massachusetts, explains that the firm has to date modeled over 650 CDO deals and updates most CDO deals each month with asset-level information extracted from trustee reports. “The analytics are primarily designed for clients to put in different default and recovery scenarios, and stress-test the tranches of the deals,” he says.

The BMA’s Cancell says the increasing number of deals modeled on Intex this year has allowed people to check out deals that they do not own, whether they are dealers or investors. “It is a big change that has definitely helped the secondary market this year,” she says.

Eight underwriters have released for general inspection Intex transaction documentation on most CDOs they have lead managed. These banks – Goldman Sachs, Morgan Stanley, CSFB, Lehman Brothers, JPMorgan, Merrill Lynch, Citigroup, and Wachovia – account for two-thirds of Intex’s modeled deals, about 400 transactions. Banks accounting for the remaining one-third of deals have not yet agreed to allow their data to be made public.

Wilner says that Intex has almost completed its job with US cashflow deals and that the firm is now beginning to collect data on synthetic and non-US transactions.

“The increased transparency provided by Intex is very positive for the CDO market. Intex puts analytical capabilities in the hands of investors in an efficient and user-friendly way,” says Ross Heller, vice president on the CDO syndicate and trading desk at JPMorgan, the most recent addition to Intex’s client list.

And more banks are set to follow. Speaking at a BMA’s CDO conference held in New York in September, representatives from Bear Stearns and UBS stated that they were also considering posting deal documentation on Intex. “Almost every bank has posted their deals on Intex; it is something that cannot be ignored and I expect the remaining banks to follow suit,” says a CDO banker. “This would be something of a change of course for Bear Stearns, which has its own CDO valuation model.”

These initiatives are stimulating a nascent market in the trading of CDOs. Early secondary market activity – namely trades done prior to June 2002 – consisted mainly of agency trades done on a best-effort basis.

Some investors, who experienced a period of consistently high default rates, were motivated to sell because they viewed the risks that they held to be different from when the deal was originally launched. One recent example is Pacific Investment Management’s liquidation of Abbey National’s $16 billion CDO portfolio in June.

However there has been other more conventional secondary market activity this year, particularly in senior tranches. Bankers estimate that about $1 billion of senior CDO paper has been traded. Other tranches, such as mezzanine notes, have been on the increase too.

For Goldman’s Thomas Marx, the mere existence of secondary trading desks at banks is a good illustration of liquidity in the market. The major underwriters are responding to increased demand from new investor types, such as principal finance desks and hedge funds.

Soros Fund Management and Cargill Investor Services have most recently been rumored to be bidding for CDO paper in the secondary market. And this is all good news for a market that was previously predominantly dealer driven.

Hedge funds have constituted the fastest-growing investor base in the CDO universe because they have the structural expertise and ability to move quickly in the market. They are natural buyers of distressed senior collateralized debt obligations due to their analytical ability to break down CDOs. Many investors have stayed away from the market because of the amount of analysis involved.

“Each year you see developments,” says Marx of Goldman Sachs. “Now with systems that allow for daily analysis, with clients demanding that dealers share more information, and increased supply of seasoned CDO tranches in the market, you are seeing dramatic growth in the secondary market. This will help transform the market into a more efficient one.”

What’s on offer in the CDO market Intex Deal modeling platform. Updates data on the transactions on a regular basis, usually monthly, with information on the asset and liability sides. 650 deals, open to non-investors of CDOs. Wall Street Analytics Deal modeling platform that allows investors to run price-yield analytics, project cashflows and coverage tests, download collateral information, and track exposure across portfolios of CDOs. Has a library of over 350 CDO deals. RiskMetrics Credit modeling of the collateral portfolio with detailed handling of the CDO waterfall structure. Produces individual tranche performance distributions, fair-pricing levels, shadow ratings, and sensitivities to individual issuers. Investment banks Cashflow modeling and analytics systems that allow default and recovery scenarios to be applied to portfolios and yield outputs to be viewed. Moody’s Provides diversity scores, weighted average rating factors, monthly performance data on CDOs. Planning to put out a CDO performance data model that investors can use to evaluate CDOs. Standard & Poor’s Provides information on the underlying portfolios, but also pre-sale reports, manager focus reports and performance measures. CDO Evaluator examines how portfolio credit quality is impacted with changes in a portfolio’s ratings, maturities, levels of industry diversification, and size of individual asset positions. Fitch Manager rankings, pre-sale and rating criteria reports. Default Vector Model allows investors to examine portfolio credit quality. Creditex Real-time data providing bid-offers on 182 markets to aid transparency of the underlying credits used to price CDOs. Used by 90% of the trading desks. Bond Market Association CDO Transaction Library provides information on specific CDO transactions previously unavailable to those outside that deal, including swap agreements, offering memoranda, indenture documents, which outline the responsibilities of all parties involved in a transaction, and monthly trustee reports.