View Full Version : Collateralized Debt Obligations (CDOs), circa 2000-2003 (MBIA safe, Merrill assures)

02-26-08, 12:31 AM

SOUTHAMPTON, Bermuda (BestWire) - Collateralized bond, debt or loan obligations reached $100 billion in 1999 and are expected to grow dramatically this year and next as a means of improving fixed-income portfolio management, with new variations that are proving especially attractive to managers of captive insurance companies, an investment expert said. Jack Meskunas, senior vice president of investments and director of special accounts at Prudential Securities, spoke May 16 at ICAP 2000, the International Captives Conference.

Meskunas pointed out how collateralized debt obligations enable portfolio managers to apply risk-management techniques to stabilize rates of return, match investment and risk durations and manage volatility. "By risk management, I refer to managing asset quality," Meskunas said. Collateralized debt obligations allow portfolio managers to "pick their spot on the credit curve, although the key decision portfolio managers face is picking the right asset managers," he said.

Collateralized debt obligations consist of a mix of investments, usually in six portions. A portion of highly rated bonds anchors the package, while successive portions of lower-rated and unrated bonds provide the investor with a mix of risks. Returns on a well-managed portfolio of these instruments vary between 15% and 22%, Meskunas said. Because the mix includes lower-quality investments, the package might fall below investment grade, so elements of the package often are over-collateralized. Meskunas used as an illustration the HarbourView CDO II, a $7.5 billion subsidiary of Oppenheimer Funds.

The top two portions are over-collateralized by 122%, the third and fourth by 112% and the lower classes by 107%. The effect is to enable the collateralized debt obligation to earn a top rating. Meskunas said that a new wrinkle attracting interest from portfolio managers, and especially captive managers, is known as principal-protected notes. In this case, the collateralized debt obligation is mated with U.S. government Treasury strips or other top-rated guarantees so "in effect, the maturity value of the CDO is guaranteed by the U.S. government," Meskunas said. "As long as the government is solvent, the CDO will perform," he said, noting that improving quality in this manner can cut return rates by almost half.

The package depends on the underlying creditors making repayments, and default rates of 2% typically are built into pricing. Collateralized debt obligations come in two forms: those with an arbitraged or market value, which account for less than 5% of the market; and "cash flow" collateralized debt obligations . "In the former, the asset manager attempts to trade the market, to find opportunistic differences within the market to enhance yield," Meskunas said, noting that no arbitraged collateralized debt obligations have been issued recently.

In cash-flow collateralized debt obligations, the asset manager "puts together and manages a portfolio based on underlying creditors making their payments," Meskunas said. Collateralized debt obligations are traded like individual bonds. Buyers receive a single statement, interest is paid monthly, quarterly or semiannually and portfolio managers enjoy a more diversified spreads of credit rating, industry, issuer and coupon type.

CDOs Reposition for Future Growth, Despite Volatility - Oct. 31, 2000 - Businesswire

Standard & Poor's--After several years of explosive growth in the U.S., 2000 is seeing the repositioning of the global collateralized debt obligation (CDO) market for the future, according to Richard Gugliada, a managing director in Standard & Poor's Structured Finance Ratings group overseeing derivatives, CBOs/CLOs, and market value/managed funds.

Despite the volatility of these structures, which temporarily stunned international markets in 1999, CBOs/CLOs have not only recovered completely but have gone on to blaze new trails. With a prevailing focus on experienced investment managers, investors are now eagerly buying CBOs and variations on this theme. The future of these products is bright, particularly considering the changes in the European markets being wrought by the euro.

In addition, new applications of the CBO platform crop up continually, including CBOs composed solely of CBOs, and CBOs of asset-backed securities (ABS). These repackaged transactions provided a large new source of liquidity for the difficult-to-place subordinate and mezzanine debt offerings of other structured products.

Market value structures are finding new applications as warehouse
financing vehicles not only for corporate loans but also for certain consumer products, particularly residential mortgages and margin loans. These deals offer issuers greater flexibility in their warehouse lines in return for a small reduction in leverage.

Part of the growth in the credit derivative market includes credit derivatives on pools of underlying credit risks or collateralized debt obligations (CDOs). These transactions too are relying heavily on CBO technology to manage and measure risks. Together with developments in bank regulatory capital requirements that encourage the active use of credit risk management techniques, the CDO is likely to grow rapidly.

For additional information about the global CBO/CLO market, please see Mr. Gugliada's article, titled "CBOs/CLOs Blaze New Trails."

They Sold the Derivative, but They Didn't Understand It - July 20, 2001 - New York Times

AMERICAN EXPRESS "did not fully comprehend the risk" it was taking, explained its chief executive, Kenneth I. Chenault, as he announced corporate America's latest bath, this one for $826 million.

The saga of this bath reflects many trends of the recent boom. Companies took risks to get the kind of profits that would impress Wall Street, sometimes involving derivatives. When prices were high, they had no fear.

The American Express mea culpa also is representative of how corporate America is responding to the new environment. It is firing people, with as many as 5,000 jobs to be eliminated, in the hope that cutting costs will produce profits. It is more reluctant to take risks on investments. And while it was quite willing to buy back its own stock at high prices last year, now it will buy fewer shares.

As derivatives go, collateralized debt obligations are not all that complicated. A diversified collection of junk bonds or risky bank loans are put together, and then securities backed by that collection are sold. The riskiest of them, sometimes called toxic waste, will pay out only if everything goes right. The best will be fine unless the entire portfolio defaults, and so on through the quality spectrum.

American Express went big for them in 1997 and early 1998. Back then, recalled Jeremy Gluck, the Moody's expert on such things, the people who packaged those securities sold them with explanations of what would happen if 2 percent of junk bonds went into default each year. Now the default rate is 8 percent, and investments that seemed safe are producing losses.

American Express assumes the default rate will not improve until 2003.

As it happens, a leading packager of collateralized debt obligations is none other than American Express, which now admits it did not understand the risks very well.

Such ignorance may not be uncommon. "There are all kinds of transactions going on out there where one party doesn't understand it," Richard M. Kovacevich, the chief executive of Wells Fargo, said in an interview yesterday.

That lack of knowledge is a function of the strides that have been made in financial engineering. Derivatives make it possible to shift risks in ways that were undreamed of even a decade ago. But the computer models used to figure out how to value those risks are sometimes not very good. "Most of the pricing is done on a very unsophisticated basis," Mr. Gluck of Moody's said.

Collateralized debt obligations are still selling well, and pricing is more realistic than it was in early 1998. But American Express says it will not take such risks again, although it will keep manufacturing such derivative securities to be sold to its institutional clients. (Would you patronize a chef who won't eat his own cooking?)

The newfound aversion to risk is not restricted to American Express. Banks are charging higher interest rates and demanding more covenants on corporate loans, thus tightening credit for many borrowers at the same time the Federal Reserve tries to make borrowing less expensive. Capital spending is plummeting and industrial production is at recessionary levels. But recession has been averted because consumers are still spending.

It is the great dichotomy of 2001, but it is not a split that can endure forever. Individuals, in their roles as investors and consumers, are showing they expect an early recovery. But much of corporate America is preparing for a period of sustained sluggishness. Hopes for recovery may ride on which side concludes it was wrong.

Standard & Poor's: CDOs Fastest-Growing Asset in European SF Market - PR Newswire - August 8, 2001

Standard & Poor's today announced that collateralized debt obligations (CDOs) are the fastest-growing asset class in the European structured finance market. In addition, the number of European CDO transactions continues to grow, underscoring the depth to which the European market has embraced this asset class, according to a report published today.

Unlike its U.S. counterpart, the European CDO market has been principally driven by balance-sheet transactions rather than arbitrage transactions due to the limited availability of European high-yield collateral. Nonetheless, the three arbitrage CDO transactions completed in the first half of this year -- Panther CDO 1 B.V., Duchess 1 CDO SA, and Mayfair Euro CDO 1 B.V. -- contained a range of assets, including European and U.S. high-yield bonds, European investment grade bonds, and leveraged loans.

Stroma Finston, director and head of the European CDO group within Standard & Poor's Structured Finance group, noted that additional arbitrage transactions are expected to hit the market during the second half of 2001.

The report, titled "Cash Flow CDOs: Continued Growth Despite Economic Risks," also contains a complete review of global corporate default rates and credit quality, particularly in relation to the high yield market, during the first six months of this year. Additionally, there is an overview of CDO market trends and the leveraged loan market, and a discussion of the ultimate recovery levels of defaulted collateral assets in CDOs, as well as a summary of CDO sector performance during the second quarter and first half of 2001.

And this one takes the cake:

Bond Insurers: MBIA's Triple-A Safe Despite CDO Exposure, Merrill Says, By Jacob Fine - April 2, 2003 - The Bond Buyer

MBIA Insurance Corp.'s triple-A credit quality is not in danger due to its exposure to collateralized debt obligations and credit default swaps, according to a Merrill Lynch & Co. report released last month.

"Given the monitoring systems, the strength of the balance sheet, the ample liquidity, and a track record of clever solutions to problems, we think the MBIA guarantee will remain strong," wrote John Hallacy, Merrill's managing director of municipal research and author of the report.

The Merrill Lynch report followed a negative report from Fidelity Capital Markets Group, a broker-dealer subsidiary of mutual fund giant FMR Corp. that focused on the insurer's exposure to collateralized debt obligations and credit default swaps. Fidelity had sent its report to its client base of financial advisers and money managers, advising them to reduce MBIA-insured municipal bonds in favor of other insurers.

Another highly critical report of MBIA was published by the New York-based Gotham Partners Management Co. hedge fund firm in December, but has since drawn the scrutiny of Wall Street regulators. Gotham was simultaneously betting the price of MBIA stock would fall by selling borrowed shares.

"However, facing no immediate threat, the company continues to possess ample liquidity for reasonable scenarios that may be speculated about at this time," the Merrill report said.

MBIA's capital ratios are moderate by industry standards, at 144 to 1, according to the report. The insurers reported claims-paying resources, including soft capital lines, of $11 billion at the end of fiscal 2002, and statutory capital of $5.4 billion. Those levels represented, respectively, 173% and 222% increases over 1993, the report stated. That compares to a current net par exposure of $497 billion.

MBIA disclosed a net par outstanding of $66 billion in collateralized debt obligations at the end of 2002, 14% of which is rated below double-A, according to the report. Only 3% of that exposure is non-investment grade.

The Fidelity report focused on the earnings volatility created by an $82 million unrealized loss the insurer incurred last year by adopting the use of third-party prices to mark to market its portfolio of CDOs.

While somewhat concerned about some of that exposure, "over a long period of time MBIA has proven they are on top of events and can be creative in the steps they take to maintain the fiscal integrity of the company," the Merrill report stated.

MBIA declined to comment on the Merrill report.

All three of the major rating agencies -- Moody's Investors Service, Standard & Poor's, and Fitch Ratings -- have maintained the insurer's financial strength ratings at triple-A.

During the first quarter of 2003, MBIA insured 367 municipal bond issues for $15.54 million, coming in second to Financial Security Assurance Inc., which insured 401 issues for $15.6 million, according to Thomson Financial.

02-26-08, 09:55 PM
And this one takes the cake:
Great finds. The magic of magical thinking! What other magical thinking is still with us that is yet to be revealed in the harsh light of reality?

03-08-08, 05:39 PM
Funny to read: