Rebuilding a stronger structured credit market

Sponsored foreword

More than 10 months into the credit crisis, it is a challenging task to write a foreword for a product area which is still going through a major re-think that will no doubt affect the landscape of the banking sector when the dust settles.

For the fourth anniversary of this guide sponsored by Calyon, we attempt to draw a few lessons learned from the past trends discussed in the previous guides and perhaps to make some projections into the near future. If one believes that structured credit products are here to stay in the years to come, these lessons could be useful guidance to help rebuild a stronger industry.

"CDOs are able to offer higher yields than similarly rated securities, so bolstering demand" (2007 ABC Guide)

Recall that it was the constant hunger for yields in a prolonged low-spread environment which encouraged innovation, complexity or increased leverage to reach target returns. With the widening experienced in both the single-name corporate and ABS arena, be it driven by system-wide factors or fundamentals, we expect that investors will slowly return to vanilla, single-name or low-leverage investments before coming back to structured credit.

In addition, the complexity demonstrated by cashflow CDOs of ABS, or CDOs brings home the cliche in investments: if you don't understand it, don't buy it. Clearly the preference for simple structures that investors can better understand is the common theme; hence an increased demand for first-to-default baskets, back to the 2000 era when structured credit market was in its infancy. Transparency is also another important topic discussed amongst market participants. Improvement in the availability of, and the ease of accessibility to, portfolio information and legal documentation for structured credit products would help restore some confidence in the marketplace.

"The downside (of single-tranche CSOs) for arranging banks and dealers is the need to hedge the residual risk when they buy protection on just one tranche."

(2004 ABC Guide)

Whilst it has always been clear that the residual risk for arranging single-tranche CSOs needs to be managed, the difficulty of finding investors for the unsold parts of the capital structure in a single-tranche CSO (especially the super-seniors) became magnified when spreads widened dramatically and as monolines, conduits or SIVs themselves were facing their own challenges.

2004 was the year when the market advertised the advantage of single-tranche CSOs over full capital structure deals as they allowed for tailor-made investments, optimised risk/return and customised payoffs. A full capital CSO was placed in April 2008 in what may be a sign that the way forward for dealers would be to keep less risk in their correlation books and have a better match between all parts of the capital structure, starting by pre-placing the super-senior in managed form. With the correlation for super-senior tranches close to historical highs, and several dealers still trying to hedge such risk with a limited number of protection sellers, value is expected to remain until defaults start occurring. Should this happen, market participants may shift their focus from systemic to idiosyncratic risk, which would result in a drop in correlation, even if pre-crisis level might not be seen for an extended period of time.

"Citi says we had better get used to them (CPDOs) and their effect on the market. Others think they are too good to be true."

(2007 ABC Guide)

CPDOs and other market value structures are currently subject to different levels of rating agency reviews, some of which have already led to multiple downgrades. We do not expect CPDOs, at least in their original form, to resurface in the years to come. Rating agencies are currently under the spotlight on numerous topics, including issues such as conflicts of interest or appropriateness of rating market value transactions. We believe that going forward and, at least in the near term, rating agencies will go back to a period of austerity and be less receptive to rating new innovative structures.

Whilst we have not seen the end of the tunnel just yet, some signs of positive vibes do exist: the first CLO priced with loans not coming from the loans overhang, the support of the central banks in providing liquidity, the disclosure of a majority of losses suffered by the banks, the successful fund-raising for numerous distressed and recovery funds are just a few such examples. Few would disagree that the roadmap to structured credit markets will be a different (and very likely less complex) one come the next guide in 2009. But, more likely than not, structured credit products are here to stay as numerous investors will always need to access the diversification, the flexible risk/return and the tailored payoffs that such instruments offer, even if it means simpler, more transparent and easier-to-value products.

Ally Chow

Global Head of Product Management and Origination

Structured Credit Markets - Calyon

Tel: +44 20 7214 6643

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