Struggle for credibility, desirable deal terms keep CDO market at virtual halt

By Jennifer Lanning Drey

Portland, Ore., Oct. 24 -Investor uncertainty, lack of money to be made, risk aversion and desire for clarity are combining to prevent activity in the market for collateralized debt obligations (CDOs), sources told Prospect News.

The virtual silence is lending itself toward the question of 'if,' and not just 'when,' particularly as the bond and leveraged loan markets are both moving forward on their paths toward full-blown recovery following the dislocation that cut through the credit markets this summer.

The lack of mortgage-related asset-backed CDO issuance makes sense, as market participants seem to agree that that particular aspect of the investment space is fundamentally broken.

However, on the corporate side, there may be money to be made again - just not right now, since many CDO investors have become mistrustful of such products, given the troubles they faced earlier this year and the general negativity now surrounding them.

Consequently, the corporate CDO market is suddenly challenged with bringing comfort to investors who have become more mindful of wanting to understand the underlying securities in the CDOs before they will invest in them again.

But the nature of CDOs is that they are private transactions whose underlying securities are not known, said Mark Adelson, partner in Adelson & Jacob Consulting, a firm that develops strategies for buyside and sellside market participants.

Fixed income investors had gotten comfortable with the opaqueness of CDOs until the subprime-related market turmoil arose and many CDOs were subsequently downgraded, leading investors to then question what they had actually invested in. The aftermath is that investors now have a stronger desire to be well versed in the securities underlying their investments, and consequently, the lack of transparency found among CDOs has become harder to market.

Of the structured products that have suffered from the recent dislocation, multiple sources said collateralized loan obligations (CLOs), which are backed by leveraged loans, have the highest chance for recovery.

More than nervousness

Separately, a buyside source said the issues that are currently preventing a meaningful regeneration of the CDO market, and more specifically the CLO market, are more complex than skittishness among investors.

The first trouble spot is that the triple-A financing rate widened over the summer with the market dislocation and has not yet settled at a steady and attractive position, the buysider said.

Of course, that hurdle will be surpassed as long as the loan market holds up and the rate becomes attractive again, which is expected to happen sometime during the fourth quarter, sources said.

The bigger issue, the buysider said, is that the market shakedown caused a dramatic change in warehousing terms in relation to CLOs. Suddenly, CLO managers are being asked to take first-loss positions on CLOs - and a large majority probably aren't willing to do so.

One possible solution is that a third party will step in and take the first-loss position on new CLOs, which is a prospect already being discussed between bankers and at least one potential third-party investor, the buyside source said.

Some of the managers with a bigger appetite for risk, along with hedge funds or CLO-only managers also may be willing to take first-loss positions - but many won't.

"I suspect there's some level of innovation to take that risk," said the buyside source.

"Given all of the incentives that Wall Street has to sell deals right now, somebody will find a way, but I can't believe it will be in the fourth quarter on the warehouse side."

Need for direction

As in the other markets where new issuance came to a late-summer halt, a need for clarity on the level of returns that may possible for all parties involved in the reshaped market is another key factor cited by sources as a reason for the inactivity in corporate CDO issuance.

More clarity is needed from the new issue markets, said an investment bank CDO source with regard to key factors that will lead to a market recovery.

"Things need to start posting at par, or close to par, with high coupons versus big discounts. I think some managers are waiting because that's what they want to see," the source said.

Not broken

In Adelson's view, it goes too far to say that the CDO market - at least on the corporate side - is broken and needs any sort of repair at all. He believes the fact that CDO issuance is unprofitable right now is a natural consequence of the credit crunch that followed market dislocation that began in late June.

No one needs to do anything to resolve it, he said, because nothing has changed.

Multiple market sources said CDOs are a fundamentally good product, which boosts their potential for coming back around.

"People are mindful of the cycle," Adelson said.

Months or years?

On the corporate CDO and CLO side, most market sources who spoke to Prospect News believe the market will eventually recover to a level close to what it was earlier in the year.

U.S.-based CDO issuance totaled $235.89 billion through the second quarter, according to figures released by the Securities Industry and Financial Markets Association.

However, most market sources also said a recovery is not likely to be seen in the near term, and some thought the market may never come back to what it once was.

One buyside source said a meaningful recovery is unlikely to happen within the next year because ideas are stubborn, and inaccurate or incomplete information is likely to affect opinions in the short term.

The source believes there is more "gloom and doom" surrounding CDOs than is justified and thinks that will lead some investors to make generic investment decisions.

Along those lines, Adelson doesn't expect to the CDO market to be out of the woods before 2009 since mortgage loans will be resetting through 2008, which means bad credit-related news will continue to emerge through that period, prolonging the current negativity being directed at the CDO market.

Admitting that it is a "painful prospect," and also just a guess, Adelson said he thinks it is possible that a turnaround will come in 2010.

During its quarterly earnings conference call for the third quarter, Citigroup's chief financial officer, Gary Crittenden, said he was not optimistic that financing instruments such as CDOs would ever be able to regain a foothold in the market.

However, the investment bank source was more hopeful and expressed the view that positive CDO market opportunities are likely to come back around shortly, at least for the major investment banks.

When they do come back around, most CDO investors will likely be looking for safer transactions than in the past, so a market comeback will probably begin with triple-A-rated, lower-levered transactions, the source said.

The basics of what makes a CDO are what they always were, and therefore the triple-A buyer will eventually begin buying them again, said the buyside source.

"Fundamentals always win in the end."

Time for change

On the other hand, sources were in agreement that the market for CDOs whose underlying securities are mortgage related is unlikely to recover without fundamental changes being made.

In their current form, products in the asset-backed securities CDO space have lost the diversification that is the inherent idea behind CDOs, Adelson said.

Recent downgrades by the ratings agencies have further caused them to lose credibility.

Therefore, asset-backed securities CDOs will come back if, and only if, the market returns to its roots and creates a new, more diversified product opportunity, said Adelson, who didn't rule that possibility out.

"When you achieve real diversification, they work great," he said.

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