Highly negative press coverage and the appearance of a number of obituaries for some of the more sophisticated and innovative structured finance instruments in 2007 and early 2008 did not appear to form the basis for a very bright future for CDOs. As Lehman Brothers put it: "A cloud of uncertainty continues to hang over the structured credit market (and) many investors are asking not 'when' but 'whether' the CDO market will normalise."
Even amid the wreckage of late 2007, however, CDOs in their basic balance sheet form continued to be issued in sizeable volumes. In December 2007, Rabobank issued a long-awaited EUR7.5 billion synthetic balance sheet CDO, Best SME 2007 BV, backed by loans to Dutch small and medium-sized companies. The lion's share of this transaction was retained by the issuer, with the much smaller B, Aa2 and C rated tranches - collectively worth a little over EUR300 million - privately placed.
A vanilla future
While bank balance sheet deals, SME CDOs and other structures collateralised by, for example, project finance and infrastructure-related facilities ought to emerge from the crisis of 2007 and 2008 relatively unscathed, for the foreseeable future it is difficult to see some of the more heavily structured or leveraged transactions returning to favour. It is equally hard to imagine instruments viewed as being highly opaque - such as CDOs-squared - making a comeback any time soon.
A major question mark for 2008, says Moody's, is the recovery of investor confidence. "This is unlikely to occur until the effects of the subprime crisis have been fully measured, especially on the financial institutions." With fresh writedowns being announced well into 2008 by top banks, it seems we are still a long way from ascertaining the full extent of subprime exposure.
Moody's adds: "The turn in the credit cycle and the forecast increase in corporate default rates are also likely to start affecting the performance of speculative-grade issuers and therefore heighten investors' caution."
As a consequence, new issuance volumes in 2008 are expected to drop between 30% and 50% compared with 2007. As Moody's notes: "We expect the CDO investor base to start reassessing their risk positioning - a process that is likely, in light of the lessons learned from the subprime crisis, to result in a shift back towards a fundamental analysis of underlying risk."
Investors will also start demanding better reporting transparency and less complexity. "Investor demand," says Moody's, "will be driven by the market's capacity to respond to an increased desire for information transparency in terms of underlying and structural risks, so that they can focus on deeper fundamental analysis and actual risk transfer."
Investors are wary of structures that are exposed to high market value or correlation risk. "This," says Moody's, "will substantially limit prospects of multi-layer structures such as SF CDOs."
Nevertheless, with CDOs offering a tried and tested means of achieving credit risk transfer, bankers believe a number of asset types may provide suitable collateral for CDOs in the foreseeable future. Some, for example, point to Islamic finance as a potentially fertile source of diversification for the market, reflecting the recent explosion in issuance of Islamic bonds (sukuk).
According to data published by S&P, the size of the sukuk market reached $60 billion in 2007 - a far cry from as recently as 2001, when the market was worth just $500 million. With issuance continuing to expand in this market, the Islamic bond asset class is gathering the sort of critical mass that would make it a candidate for credit risk transfer via the CDO mechanism.
"Assuming credit market conditions return to normal, Standard & Poor's expects the sukuk market to top the symbolic mark of $100 billion in the next couple of years," the agency says.
A stable base
So much for the foreseeable future. What of the much longer term, when memories of the crisis of 2007 fade, as they inevitably will, and the hunt for yield is rejoined? Indeed, as markets appeared to stabilise in the early summer of 2008, a handful of market commentators were already expressing disquiet at the readiness of policymakers (shorthand, in effect, for the Federal Reserve) to respond to market crises by scything interest rates and potentially unleashing new bouts of excess liquidity.
Assuming that liquidity does make its way back to the market, stoking fresh innovation and encouraging a return to leverage, what steps need to be taken to ensure that there is no repeat of the seizure of the markets that characterised the height of the crisis in 2007?
Already, scores of think-tanks, multinational entities and industry associations are exploring ways of strengthening financial stability as a means of pre-empting the next crisis, with three discussion areas of particular importance for the future of CDOs: regulation; the rating agencies; and reporting and accounting standards and disclosure.
"Timely reporting, transparency and audited infrastructure will play a key role in ensuring confidence returns for investors. Technology used effectively will help deliver this solution," says Brett Paton, chief technology officer of CDO Software.
Although the concept of regulation is anathema to many market participants, it is likely that financial institutions will need to be more heavily regulated in the future. That was one of the conclusions drawn from a survey of 112 firms undertaken by law firm Norton Rose in April 2008.
In the survey, 53% of respondents "agreed that lead regulators or central banks should be given more powers to intervene in the management of financial institutions". Although plenty disagreed (38%), the signs are that events on the ground, rather than simply faith in the workings of the free market, are heavily influencing opinion. The regulators and central banks have been active in trying to mitigate the effects of the crisis and, when they have been criticised, it has tended to be for inactivity or indecisiveness rather than over-zealous interventionism.
How, precisely, the CDO market would be impacted by more intervention from regulators is unclear, although many market participants believe that more will need to be done to monitor and regulate originate-and-distribute strategies that may have been subject to abuse by some players.
As the Institute of International Finance's crisis report, published in April 2008, comments, the upheavals of 2007 call into question "many aspects of the 'originate-and-distribute' model and structured products. It is clear that realising the full constructive potential of that model will require focused attention to address shortcomings in market practices that were seen in the run-up to the turmoil."
In the sphere of regulation, however, the liveliest debate is likely to centre on the role of the rating agencies, which once again found themselves at the eye of the storm in the recent crisis. Already, entities ranging from Iosco to the European Commission are working on a range of proposals involving varying degrees of added oversight of the rating process and of how the agencies are remunerated.
So too is the Institute of International Finance, which addressed the issue of rating agencies in its report on Market Best Practices released in April 2008. "Our report (notes) that there are some outstanding differences between us and the agencies," explained IIF committee member, Richard Waugh, president and CEO of Scotiabank, when the report was released. "We are recommending that ratings models should be consistent with industry-developed standards and subject to independent review and external validation, but unlike the review and validation that exist for the internal ratings and risk methodologies at banks, we are proposing that a means be established that would enable the independent, industry-based, external review of the methodologies, models and internal governance processes of rating agencies."
Increased oversight of the rating agencies need not be unduly onerous for the agencies themselves, and investors themselves need to shoulder more responsibility for understanding the role of the agencies and for interpreting their ratings more appropriately.
It is telling, for example, that one of the recommendations made by Iosco in its recent report on the agencies is that "the CRA (credit rating agency) should assist investors in developing a greater understanding of what a credit rating is, and the limits to which credit ratings can be put to use."
That may sound like a blindingly obvious requirement. But if it had been observed more studiously in the past, the recent crisis may not have claimed so many casualties among investors in the structured finance market who assumed that a low probability of default and guaranteed liquidity were one and the same.
A third discussion area that is likely to have an impact on the longer-term evolution of the broader market for credit risk transfer concerns disclosure standards and accountancy guidelines in general, and more particularly the mark-to-market requirements that played such a pivotal role in the liquidity crisis of 2007.
By early 2008, credit strategists were voicing concerns that it had been the shackles of the mark-to-market regime rather than macroeconomic or credit-related forces that had exacerbated or even caused illiquidity and muted demand in the CDO market. "We have felt that fundamental credit risk and mark-to-market risk were massively decoupling at some points in the crisis," is the view of Nicolas Christen, head of CDO structuring at BNP Paribas. "For example, we are aware of a number of investors who saw great value in senior tranches of synthetic CDOs from a fundamental credit perspective, but who were unable or reluctant to invest because of the mark-to-market risk given the current volatility."
Julien Turc, credit strategist at Societe Generale, has similar misgivings. "The $1 million question today is, are people going to be prepared to take the same sort of mark-to-market risk as they used to? Our guess is that they won't, which will make it very difficult for volumes in the CDO market to recover," he says.
That would suggest that there is a pressing need to reassess how accounting guidelines are applied. For bond insurers, in particular, the accounting requirements surely need to be revisited, because uncertainties over the future of the monolines played a prominent (but possibly unnecessary) role in the global financial crisis of 2007 and 2008.
Asking the basic questions
No amount of reform, however, be it of regulatory standards, rating agency processes or accounting standards, can compensate for poor management, and one of the most striking features of the recent crisis has been the mea culpa admissions that have come from a number of key market participants.
From MBIA, for example, has come the acknowledgement that "the company missed some of the warning signs and is now paying the price"; while from UBS has come the humbling recognition that "we could not see the forest from the trees" and that "we ... no longer asked the basic questions."
When the next wave of activity and innovation begins in the structured finance market, asking - and answering - the basic questions should be an obligatory starting point for all market participants.
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