Keynote speaker Curtis Mewbourne, executive vice-president of corporate credit and investments at Pimco, opened the Congress with a bullish view. Fifteen years ago, 100% of corporate issuance was dollar-denominated. Euro issuance began in 1999 and now currency issuance is much more diverse. Similarly the proportion of high-yield issuance has soared both sides of the Atlantic to represent about 30% of the US credit markets (17% five years ago) and 10% in Europe (1% five years ago).
Diversification on the demand side is equally as powerful, said Mewbourne. Some 60-70% of Pimco's credit mandates now come out of the US. Interest from the Middle East particularly is picking up as the high price of oil encourages the flow of dollars to the region. In credit derivatives, new technology and new users are boosting liquidity and creating new trading opportunities for traditional investors. In short, global demand for credit remains strong, leading to more globally balanced issuance. "Credit derivatives are here to stay," proclaimed Mewbourne, "and managing credit risk requires a more robust macro and more micro framework" - themes revisited by the Congress comprehensively during the two-day event.
Multi-use software gets the thumbs-up
Cross-asset class and multi-functional technology was the focus of the presentation by Luke Knecht, chief operating officer at Deerfield Capital Management in Chicago, entitled 'Systems support for CDOs'. "The best and most cost-effective software systems solutions arise when you can deploy a single system across multiple functions," he said. But the more diverse your business is, the harder it is to do that, added Knecht, whose firm has some $10 billion-plus under management and runs 19 CDOs. Having adequate middle-office and risk management software is vital in order to demonstrate compliance with the regulators. But there are other compelling reasons to install the right systems.
"Giving investors a reason to doubt your ability to measure, compare and report on the attributes of the portfolio can put you out of business," said Knecht. "If you remove that as an issue it can take you to fantastic heights." Any opposition a risk manager might face in implementing systems development is easily answered by making people aware of the "catastrophic disaster of compliance failure", says Knecht. "It is now a competitive necessity to have a strong internal compliance function."
The problem with base correlation
Soren Willemann, lecturer in the Department of Accounting, Finance and Logistics at the Aarhus School of Business in Denmark, says that CDO market participants are paying increased attention to the base correlations methodology for predicting default correlation. Correlation models have come under considerable scrutiny this year, as cracks in the widely used compound correlation model were exposed following the autos downgrades in May.
Although base correlation has the advantage of permitting relative valuation of off-market tranches, Willemann finds that there are problems with using the model as a quotation device and relative valuation tool. Using a theoretical model to examine the behaviour of base correlations, Willemann found four key flaws: first, even if true default correlation increases, base correlations for some tranches may actually decrease.
Second, base correlations depend on the attachment points for the CDO tranches. So, all else being equal, base correlations will be different depending on the CDO's tranche structure. Third, in the relative valuation framework, expected losses can go negative for steep correlation skews. And finally, the relative spread errors are small in some segments but can be very large for mezzanine tranches.
CDOs of ABS soar
David Yan, vice-president of CDO research at Credit Suisse First Boston in New York, reported a marked surge in CDOs backed by securitised assets this year, with issuance now standing at $94 billion year-to-date. Yan said the growth of these structured finance CDOs has been a dominant force in the CDO markets with issuance figures already up $6 billion from last year.
One area that has experienced significant growth is the issuance of CDOs backed by residential mortgage-backed securities. Yan anticipates that the "next big thing" will be synthetic structured finance CDOs and more hybrid deals.
Yan said that investors today prefer "pure play" CDOs, deals that offer investors access to one asset class in particular. Previous CDOs structured three to five years ago, were characterised by multiple assets in their collateral pools. This shift has occurred because "investors would rather diversify themselves" by buying multiple CDOs than let CDO structurers diversify within deals on their behalf, he said.
Until recently, structured finance CDOs performed poorly because structurers wrongly believed that diversification and arbitrage alone could adequately compensate investors for their risk; structured finance CDOs experienced multiple rating downgrades as a result.
Risk-managing CDOs: different to bonds
CDOs may "sound like a bond", but risk-managing these structures is very different, argued Nico Meijer, senior vice-president in global risk management at TD Bank in Toronto. The upside is that CDOs typically offer investors higher coupon payments for a similar rating, greater diversification and access to assets they might not otherwise have. But the risk profile of a CDO is different to that of a similarly rated bond and a CDO can be much riskier.
This includes the risk of losing 100% of the principal if portfolio losses exceed the upper attachment point; price volatility due to credit spreads, implied correlations and expected recovery rates; and the difficulties of working out the value of these structures, due to the complexity of models and lack of quoted markets. In addition, said Meijer, "you have to understand that these products don't have the same liquidity in the secondary markets as a good investment-grade bond would have." The net asset value of CDOs can also change over time, depending on changing interest rates, credit spreads on the reference entities and the number of reference entities that have defaulted.
Investors in the secondary market for CDOs should get ahead of the curve on complex deals and buy where information on collateral or structure is weak, or where there are differences of opinion, advises Douglas Lucas, head of CDO research at UBS in New York.
Lucas explains that liquidity and information provision in the secondary markets have improved considerably over the last few years, with more dealers and traders involved and a greater number of organisations providing information on CDO documentation, collateral pricing, cashflow modelling and Monte Carlo simulations.
But Lucas says that some of the best value opportunities remain in areas of the market which have a deficit of information or are very complex. These are distressed CDOs, CDOs of CDOs, middle-market loan CLOs, CBOs, CDOs with loans and bonds, barbell portfolios, managed synthetic deals, triple-A revolvers and new-issue double-Bs.
When buying secondary market CDOs, however, investors should be wary of overreliance on inaccurate or incomplete information, cashflow models and net asset value analysis. Lucas also warns against ignoring the potential for collateral prepayments and CDO calls, and advises investors to pay close attention to manager behaviour.