![Risk.net](https://www.risk.net/sites/default/files/styles/print_logo/public/2018-09/print-logo.png?itok=1TpHrpuP)
CDO shakeout puts spotlight on managers
Unsettled structured credit markets are causing investors to become more scrupulous in their collateralised debt obligation (CDO) manager choices, according to market participants.
A rise in perceived credit risk and a breakdown in secondary liquidity across structured credit markets are making investors more cautious about investing in CDOs. In particular, they are becoming choosier about the collateral managers overseeing deals, which have the ability to swap out credits and often trade names in the underlying portfolio.
“There’s really a bifurcation between those who can get a deal done and those who will take a deal at any price. And you’re seeing that more now than ever before,” said Jason Schechter, New York-based global head of CDO trading at Lehman Brothers.
Having lost billions of dollars on subprime mortgage-linked and warehoused CDO assets, dealers are also cautious about taking any assets onto their balance sheets that they might not be able to later unload.
On November 7, New York-based Moody’s Investors Service reported that, by the end of October, the global speculative-grade default rate stood at 1.1%, its lowest level since March 1995. The agency predicts this will rise to 3.6% by October 2008.
As the credit cycle turns, CDO arrangers and managers said it would become easier to differentiate between managers that were adding value and those that were not.
“When everything’s grinding tighter on a week-by-week basis, it’s very hard to tell which manager did better than the other,” remarked Kathy Sutherland, head of JP Morgan’s global structured syndicate team in London. Contrastingly, she added, rougher credit markets would produce greater differentiation between managers.
Some CDO managers welcome the prospect of higher defaults, believing it will help bolster their claim that they add more value to transactions than competitors. One US-based CDO manager who spoke to Risk said it would separate value managers from “incompetents” and “amateurs”.
But Lehman’s Schechter said it was also important not to "bind the hands" of good CDO managers through excessively strict trading rules, especially in turbulent market conditions.
“There are certain investors that always want to limit the trading flexibility of a manager when things like this happen. It is better to give the manager more flexibility rather than less, especially when the market is potentially facing a period of disarray.”
A recent report by Moody’s also stressed the significance of management fee and incentive structures to the performance of CDO managers. “The alignment of interests between the manager and noteholders is critical to ensuring the flexibility granted to the manager is used in a way that is not detrimental to the rating and noteholders’ interests,” it said.
In general, studies by analysts at both Citi and Derivative Fitch suggest managed synthetic CDO deals exhibit lower ratings volatility than static ones.
According to Citi, managed synthetic CDO tranches rated by Standard and Poor’s (S&P) underwent fewer ratings upgrades between 2004 and 2006, while credit conditions were favourable. On the other hand, S&P-rated managed synthetic CDOs experienced fewer downgrades during the credit downturn of 2003. Analysts at the bank expect investors to demand more managed deals in future as credit conditions take a turn for the worse.
The recent performance of some managers in the CDO of asset-backed securities (ABS) sector, however, might give them pause for thought. On November 21, Derivative Fitch lowered the CDO asset manager (CAM) ratings of six CDO managers, including Connecticut-based GE Asset Management, Rabobank and California-based Trust Company of the West. It placed another four on watch for a possible downgrade, including London-based Solent Capital.
The CAM ratings reflect Derivative Fitch’s assessment of the firms when managing CDOs of ABSs only. Manuel Arrive, a director at the agency in London, said it was difficult to tell whether the downgrades would affect their performance in managing other CDOs referencing corporate bonds or loans.
See also: Collateralised debt obligations - CDO managers under scrutiny
CDO managers - Do the ends justify the fees?
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@risk.net
More on Structured products
A guide to home equity investments: the untapped real estate asset class
This report covers the investment opportunity in untapped home equity and the growth of HEIs, and outlines why the current macroeconomic environment presents a unique inflection point for credit-oriented investors to invest in HEIs
Podcast: Claudio Albanese on how bad models survive
Darwin’s theory of natural selection could help quants detect flawed models and strategies
Range accruals under spotlight as Taiwan prepares for FRTB
Taiwanese banks review viability of products offering options on long-dated rates
Structured products gain favour among Chinese enterprises
The Chinese government’s flagship national strategy for the advancement of regional connectivity – the Belt and Road Initiative – continues to encourage the outward expansion of Chinese state-owned enterprises (SOEs). Here, Guotai Junan International…
Structured notes – Transforming risk into opportunities
Global markets have experienced a period of extreme volatility in response to acute concerns over the economic impact of the Covid‑19 pandemic. Numerix explores what this means for traders, issuers, risk managers and investors as the structured products…
Structured products – Transforming risk into opportunities
The structured product market is one of the most dynamic and complex of all, offering a multitude of benefits to investors. But increased regulation, intense competition and heightened volatility have become the new normal in financial markets, creating…
Increased adoption and innovation are driving the structured products market
To help better understand the challenges and opportunities a range of firms face when operating in this business, the current trends and future of structured products, and how the digital evolution is impacting the market, Numerix’s Ilja Faerman, senior…
Structured products – The ART of risk transfer
Exploring the risk thrown up by autocallables has created a new family of structured products, offering diversification to investors while allowing their manufacturers room to extend their portfolios, writes Manvir Nijhar, co-head of equities and equity…