Cash CDOs move into securities lending

Goldman Sachs has entered into securities lending trades – where it acts as the borrower – with a handful of collateralised debt obligations (CDOs) in the past few months, says Alex Reyfman, New York-based credit portfolio quantitative strategist at the firm.

The US house is pitching the idea of securities lending as a way for cash CDO managers to garner additional returns and more effectively manage risk. Most of Goldman’s transactions have involved CDOs lending out loans with total notionals of between $250 million and $400 million. The lent instruments are collateralised with cash or low-risk assets.

Clauses allowing CDO managers to lend their portfolio’s assets have lay dormant in the indentures of CDOs for years. Activity is now finally picking up because even relatively well-performing assets – such as leveraged loans, for example – are not yielding as much as managers had hoped, while origination volumes are not especially strong. “CDO managers could pocket a fee in the 25 to 35 basis points a year range through securities lending,” Reyfman says. “It’s a relatively low risk way to earn extra money in a difficult environment,” he adds.

Generally, Goldman borrows between 20% and 50% of a CDO’s collateral in each transaction. Loans have been lent out for terms ranging from three months to two years and transactions involve portions of portfolios rather than single loans. If a CDO manager wants a loan returned – to sell it, for example – they can substitute another loan in its place within the lending agreement without terminating the transaction, though only after giving suitable notice.

Before any transaction can take place, the CDO manager must ascertain from its CDO’s rating agency that securities lending will not affect its rating. For example, Moody’s conducts a review to ensure that the CDO manager has adequate knowledge of securities lending and systems in place to monitor mark-to-market valuations of loaned securities daily.

Next, the CDO manager and borrower must negotiate a master securities lending agreement. Once the agreement is established, the manager can book the periodic lending fee and put it into the CDO’s interest waterfall. This additional cashflow can help the CDO satisfy various coverage tests that determine payouts. Another benefit of the additional income is that the CDO manager is under less pressure to purchase potentially riskier assets to get the required yield pick-up.

Goldman claims that lending of securities by CDOs does not expose managers to significant additional risk. In the event that a borrower defaults, the CDO should eventually be able to liquidate the posted collateral – typically US Treasuries. The CDO is then exposed to the investment risk that the price of replacement assets is greater than that of the sold Treasuries. This risk is mitigated by marking-to-market both the Treasuries and lent asset and maintaining an over-collateralisation margin.

According to a structured credit strategist at another US dealer, who asked to remain anonymous, several CDO managers started lending out assets from their portfolios this year to dealers other than Goldman.

But some CDOs are reluctant to start lending securities. “We were pitched to by a dealer last year, but decided not to proceed,” says a US-based CDO manager. “There is a lot of natural volatility in a bear market. Securities lending is just another way of leveraging-up and we didn’t want to introduce further volatility into our portfolio,” he adds. Another US-based high-yield bond CDO manager points to the potential for loss of voting rights on lent debt. “Corporate actions that rely on note holders’ votes are not uncommon in this credit environment,” he says. “If bonds in my portfolio are up for some kind of change in structure, I want my voice heard,” he adds.

Within Goldman, the CDO initiative is part of a wider push to establish a securities lending-type business line for bank loans, claims one structurer within the US house. Goldman declined to comment on this broader business. Traditionally, securities borrowers were broker-dealers seeking to avoid costly failed trades caused by the late delivery of securities. Now, alongside risk management of existing loan portfolios by banks, borrowing the CDOs’ loan collateral could be useful to credit derivatives dealers too – providing an extra source of liquidity for shorting credits to hedge their default protection selling.
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