Set at the inception of a deal, CDO investment guidelines are meant to protect the vehicle’s noteholders. They can often include limits on the weighted-average rating factor of a portfolio and controls on certain risky industries and reference entities.
“In certain circumstances, these parameters have left managers with less flexibility to trade defensively in a period of heightened market stress and spread widening,” said Fitch.
The ability of CDO managers to trade had been further eroded by deteriorating liquidity and widening spreads in credit default swaps (CDSs). Fitch believes this is partly attributable to an exodus of banks from correlation trading during 2008 and a concomitant reduction in risk appetite.
CDS market liquidity was poor, particularly for seven to 10 year CDS trades, while bid/ask spreads had widened out, the agency observed.
Meanwhile, the massive spread widening for many CDS reference names had also caused headaches. When CDO managers replace reference entities in a portfolio, they crystallise any mark-to-market losses on the original entity. In turn, this eats away at the subordination of CDO noteholders. For managers, concern at the loss of a such a large chunk of subordination had deterred them from making substitutions, Fitch noted.
“Even in instances where the CDO has a short position, it is difficult for managers to monetise this position because of wide bid/ask spreads, which are often in excess of trading gains,” it said.
As a result of the turmoil, some CDO managers had chosen to manage with fundamental credit views in mind, as opposed to using internal models aimed at achieving the best spread or price for a given rating.
From 2007 to mid-2008, many CDO managers also sought to increase their allocation to defensive sectors ahead of the economic downtown, Fitch said. But market conditions – along with the initially-aggressive structure of many synthetic CDOs – had prevented this, the agency suggested. “In most cases, managers were unable to implement their targeted allocations, due to the cost of substitution, initial industry and obligor concentrations and limited subordination.”
For the most part, CDO managers had not pursued restructuring or unwinding trades, it said. However, some had increased dialogue with CDO arrangers and CDS traders in an effort to relieve liquidity and operating pressures.
See also: Restructuring reservations