How has the CDO market been developing in recent years?
Gugliada: Globally the market has taken off at an exponential pace. There were 320 transactions in 2002 and this year has taken off as well. The majority of the recent growth has come out of the Europe. But this year, Asia for the first time, is starting to pick up very nicely. Last year there were nine deals up until September. This year there have been 35 deals so far.
What types of CDOs have been coming out of Asia?
Gugliada: It's been a mixed bag. The majority of the transactions have been synthetics and of this type, about two thirds have come out of Australia and most of these have been smaller two counterparty type deals. Deals like that are coming out of the rest of the region - especially Hong Kong, Singapore, Taiwan and Korea as well, but they are mostly privately placed. We're seeing some of the funded type structures and the larger, synthetic and syndicated type deals emerging as well.
Is Asia more of a buyer than a supplier of CDOs to the world?
Gugliada: To date yes, Asia has surplus liquidity looking for good investment returns that CDOs provide. But in general, many buyers of CDOs eventually evolve to become issuers of CDOs as well. We expect Asia will soon become a major supplier of CDOs to the rest of the world.
Aren't the main Asian buyers of CDOs insurance companies hunting for yield?
Gugliada: That's how it started in the US as well as Europe. But over time that migrates out of those entities and into the hands of professional investors who tend to be both large buyers as well as large issuers. At the senior triple A tranche levels, it is still big bank and insurance company participation. But the mezzanine, subordinated and equity tranches mostly find their way into professional hands over time.
Lam: The money in the so-called Asian Bid is real and substantial. It's mainly in the hands of Asian banks and insurance companies. But we're finding people want control over what is happening with these CDOs. They want a better say in making decisions on selection at the very start. Asian investors can access much valuable information from the increased transparency in the markets about CDO performance, through investor reports including published research from Standard & Poor's. As a result, investors are able to demand better structural mitigants. In recent months, this trend has propelled the increased inquiries in single tranche synthetic CDO, which are custom tailored for a single investor; a typical structure would be the UOB Global Credits. We see these buyers moving from being passive investors to being active managers and sponsors of CDO deals. They're not just hunting yield, but seeking to gain technology transfer. Part of the objective of investing in CDO is ultimately to extend asset management and also structuring and derivatives know-how.
As these products develop, what new levels of sophistication are you expecting to see in Asia?
Gugliada: The main development we are looking to see is the ability to do multi-country transactions, seamlessly pulling credits out of different countries. There are great opportunities to use synthetic technology to manage a cross border transaction. There are lots of small countries, which cannot support a thriving CDO market in Asia because there are too few companies in each country. But many banks and investors operate on a regional basis, so using that synthetic technology can cross those national boundaries that exist in the cash market.
Lam: Also Asian investors tend to be more comfortable with Asian names. So one of the constraints is whether or not the pricing fits in with the structures and countries that investors want. There is always a delicate balance when managers try to structure a basket of different credits.
Is there an issue with the availability of the underlying credits? Bonds tend to get bought and held in Asia.
Gugliada: That goes back to the synthetic technology. You don't actually need the bonds to do these deals. There is a thriving short market in the hedge fund industry due to the credit derivatives market. It's now very efficient to get short fixed income instruments, which creates a tremendous opportunity to provide the feed for synthetic CDOs.
What correlation is there between the various components of a CDO package, either in terms of sector or geography?
Gugliada: What is important in a CDO is default correlation, not just a generic form of price correlation. But all the data that every rating agency has ever produced is insufficient to answer that question. We have looked at specific industries and geographies and seen how they behave. We also looked at price correlation and we found a weak linkage between default correlation and price correlation; they generally do not hold tightly together. So we have simplified correlation assumptions of 30% within industry and 20% within geographic regions.
How do you see the current credit environment affecting the supply of and demand for CDOs in Asia in coming months?
Lam: People are using a lot of these structures for arbitrage purposes and trying to make money. What we're hearing is that it is very hard to structure a good, profitable deal right now because spreads have tightened so much recently. That's why we are seeing a pause at the moment. That being said, we've rated a number of transactions this year and with the right timing, deals go to market very quickly. With all the press attention on CDOs, investor awareness is very high in Asia at the moment.
Gugliada: With the up turn in underlying credit quality, we're expecting a new wave of upgrades in the CDO market. These transactions have been built with corrective mechanisms in them.
Lam: It's a good time for Asia as we have the benefit of looking at deals that didn't happen in the past and we can understand why they did not work out. For instance there are things that we do not like to see in the documentation now that were there before.
What else is Standard & Poor's doing to boost the market?
Gugliada: Just last week we launched a new version of our CDO Evaluator. There are two critical changes in it: firstly in our emerging market methodology, where previously we assumed that each corporation in a given country would default if the sovereign defaulted. While we still hold that belief for low quality sovereigns, we've relaxed some of those assumptions for investment grade countries. We have seen with Russia and Argentina that when sovereigns get distressed, they don't necessarily put on exchange controls.
Secondly, we have gone beyond our scenario default rate as the primary output. Now it will produce the whole capital structure of a transaction, so one piece of software can get you very close to where the ultimate rating will be. We have also produced a whole suite of benchmarks, the keynote one being what we call Rated OC, which is a forward-looking indicator that encompasses all the critical rating factors into one single number.
