The CDO market has bounced back before but the impact of the current crisis could be more severe, as Lynn Strongin Dodds reports
As the sub-prime mortgage crisis unfolds, collateralised debt obligations (CDOs) seem to be at the centre of the storm. The downgrades are coming fast, and for now the future does not look promising. But the market is not dead yet. Industry participants believe that the basic premise still holds although changes will be needed to the way they are assessed.
At the moment, investors are staying away. As Jean-Baptiste Gaudemet, professional services manager of Sophis, a provider of portfolio and risk management solutions, says: "The problems in the sub-prime market have had a domino effect on the rest of the CDO market. Investors have lost confidence in some of the tranches and it is currently hard to evaluate the risk because of the volatility. For now, the focus seems to be on the safety of government bonds pushing down long-term yield."
Issuance has withered, according to the latest figures from Dealogic, a UK-based data provider. Its figures reveal that deal activity started to slow during the summer's credit crunch, with issuance plummeting by 53% to $22.3bn (€15.2bn) between June and July. For the year to 30 November 2007, $295bn in new CDOs were issued, a 13% drop from the same period in 2006 when monthly issuance was regularly above $30bn.
In 2006, CDOs were the fastest-growing debt market in the US, outpacing corporate and municipal bonds. A staggering $500bn of CDOs were sold, up from $99bn in 2003, according to industry estimates.
The jury is out as to what 2008 will bring. The corporate loan market is weathering the storm but few are willing to predict when or if the asset-backed CDO market will return. As Simon Martin, head of research and strategy at Curzon Global Partners, says: "The future of the CDO market is difficult to predict - right now most people would probably say that the market has ground to a halt and that there was no reasonable prospect of it coming back in the near term. That said, securitisation as a technique is now widespread and plays an important role in diversifying risks so even if CDOs don't come back in their current incarnation, securitisation ‘conduits' will probably come back in some shape or form."
Greg Stoeckle, head of the bank loan group at Invesco, a global investment management company, notes: "While CDOs have been around for a long time one of the current problems is that people tend to paint all of them with the same brush. They are not all generic structures and there is a significant difference between the underlying collateral classes that comprise different CDOs. I think the market will come back with collateralised synthetic obligations (CSOs) and collateralised loan obligations (CLOs), leading the way but it will require significant revisions to the underwriting standards and collateral assumptions before the market contemplates another asset-backed deal."
The CDO structure, which can include CLOs and CSOs, first came onto the scene in the 1980s. A CDO is basically a diversified pool of assets with different risk profiles that are carved into different tranches. These include senior or triple-A rated, the mezzanine portion, which is double-A and double-B rated, and the equity component which is the unrated and riskiest component. If a CDO falls into technical default, then investors in the top tier of bonds usually get additional rights. They can collect all the interest payments for themselves, potentially leaving investors at the lower end of the spectrum with losses.
Over the years, CDOs have been seen as a good way to gain access to high-yield instruments, corporate bonds, corporate loans and emerging market debt. Although these structures have had their fair share of media coverage in the past few months, this is not the first time they have grabbed the headlines. For example, CDOs with exposure to emerging markets took a hit after the Asian crisis in the late 1990s while high-yield CDOs went out of fashion after the dotcom collapse at the beginning of this century.
This time around, industry participants believe that the impact could be more severe because of the sheer size of the market and the exposure to sub-prime loans. Robert Keiser, vice-president of Thomson Proprietary Research, explains, "global CDO issuance grew in lockstep with the sub-prime market. It is no coincidence that since 2002, there has been a 300% growth in sub-prime origination and a 400% rise in CDO issuance. However, although sub-prime may have started out as very attractive collateral for CDOs back in 2004 and 2005, they have ended up being a very different risk asset with a delinquency rate of 14% as of the second quarter of 2007."
While initially slow off the mark, rating agencies have flooded the market with their newly issued low expectations. S&P and Derivative Fitch slashed their ratings on a combined $40bn-worth of securities linked to residential mortgages. Derivative Fitch lowered ratings on $29.8bn of mortgage-backed CDOs, while S&P cut $11bn worth of the deals.
According to Jason Schechtez, global head of CDO trading at Lehman, the situation has been further exacerbated by fluctuations in the ABX index, a derivatives index tracking sub-prime mortgage securities, which was launched last year. The index is a family of five sub-indices, each of which consists of a basket of 20 credit default swaps referencing US sub-prime home equity securities. It is widely used by banks and investors to hedge sub-prime mortgage risks, and shorting the index has been a favourite pastime of hedge funds this year.
In November, the index fell to new lows amid concerns that October's mortgage bond performance data would show an acceleration in the pace of deterioration, a trend exhibited by September and August loan performance data. However, the numbers were a touch better than expected, which led to a slight improvement in the index.
The other problems plaguing the CDO market have been the lack of information and warnings concerning the potential risks of the sub-prime securities. Investment banks have come under attack for their underwriting standards, and rating agencies have been heavily criticised for their analytical tools.
As Schechtez notes: "The rating agencies try to put ample cushion in their CDO ratings but the projected default rates in the underlying pools of mortgages have far exceeded their statistical expectations. The difference with the securities in CLOs is that when you have a pool of 150-200 corporates, you can do significant due diligence on each and every corporate. By contrast, a mezzanine ABS CDO may consist of approximately 100 mezzanine tranches of RMBS securitisations which are subsequently backed by thousands of individual mortgages."