Morgan Stanley CDO repack designed to test investor appetite

Morgan Stanley's offering of a repackaged cash collateralised debt obligation (CDO) is designed to test market appetite for this type of risk, said a source familiar with the deal.

"The intention is to see how the market takes this kind of a deal. There have been $77 billion in residential mortgage-backed securities repackaged recently and around $2.5 billion in commercial mortgage-backed securities - this is an attempt to see whether the same concept will fly in collateralised loan obligations," says the source.

This cash CDO - called Greywolf Capital CLO I - was issued by Goldman Sachs in 2007 and managed by Greywolf Capital Management. The repackaged deal has two tranches: an $87 million senior tranche, which is expected to attract an AAA rating, and a $43 million junior tranche rated Baa2 by Moody's Investor Services.

The offering price for the senior tranche is expected to be 89 basis points over Libor, having originally been priced at Libor plus 24.5bp, and is reportedly attracting interest from Russian banks. The pricing of the junior tranche remains unclear, but it is thought hedge funds are lining up as buyers.

The source said the Greywolf Capital CLO was sitting on the Morgan Stanley trading book, but was not sure when the bank originally purchased the cash CDO. The fact that the Greywolf Capital CLO was downgraded recently by Moody's has led one analyst at a US bank to speculate Morgan Stanley recently purchased the deal in the secondary market at a discounted price, and will be reaping a healthy profit from the repack. However, the source familiar with the deal denied this was the case. One London-based global head of structuring at a US bank also indicated this was unlikely.

"There are CDO tranches in the secondary market that are getting completely destroyed because of the lack of understanding and valuation mechanics around them. Some dealers will have their own views on these tranches because of their own models and correlation assumptions, so they buy them up, put them into special purpose vehicles and often retain them or sell pieces of them. However, I wouldn't say there is a lot of that going on at the moment," he said.

Analysts say it is the first repackaging of a cash collateralised loan obligation in the US in 2009. More common, but still not prevalent, are cases of dealers repackaging CDOs on their balance sheets for regulatory capital purposes. For instance, a dealer might repackage a mezzanine CDO tranche by putting it in a special purpose vehicle, re-tranching it into three slices (often adding some credit enhancement to the senior most tranche to attract a higher credit rating) and then sell the first-loss tranche off to hedge funds or other banks, while maintaining the senior tranche on its balance sheet at a lower capital charge.

"People in effect synthetically re-tranche an existing CDO by creating a senior and junior exposure to a particular tranche. I would say we have had just a few cases like that - we had one of that kind of deal aborted last week," said one London-based partner at a international law firm.

"In the repackaging space, most of the activity has been for regulatory capital purposes. But it's probably been more activity than actual deals closed," agreed another London-based partner at a separate international law firm.

See also: Ratings redux