In the past couple of years, the synthetic collateralized debt obligation (CDO) market has experienced significant development in Asia. Moody's Investors Service's managing director of Asian structured finance, Michael Ye, and vice president and senior structured finance analyst, Jerome Cheng, talk to FinanceAsia about the reasons for the recent growth and explain why issuance has been dominated by arbitrage deals rather than balance sheet transactions.
How many arbitrage CDOs have you rated in the past year and what do you believe the scope for this market to be?
Cheng: Last year we rated four transactions; this year we have rated five deals. They've mostly been synthetic CDOs although one of the deals has certain hybrid features with a cash bond component. Going forward, we're optimistic about the arbitrage market, although growth is dependent on when credit arbitrage windows present themselves. The windows can open and close very quickly, which explains why a number of deals get completed in a very short period of time. Because the market is arbitrage-driven, it is not easy to give a particularly accurate prediction for the number of deals, but we do expect to see another four or five deals close by the end of the year. That would make it a record year for this sector.
The synthetic CDO market in Asia has grown significantly in the past couple of years. What do you attribute the growth to?
Firstly, the market is much deeper than what it was a few years ago. Also, from the investor's perspective, we have seen more and more portfolio managers looking at synthetic CDOs as another potential source of revenue. On top of that, I think in the general market people are more comfortable with credit default swaps (CDS) and the way they trade, plus the way the CDOs actually work.
Yee: One further point to make regarding Asian investors is that their awareness of global credits has improved. In the past, for deals to get sold here, the underlying portfolios would have had to include predominantly Asian credits, but on the most recently closed transactions, the underlying portfolios have a lot more global exposure - with many US and European names included. Investors want this exposure now and the Asian portfolio managers have more experience dealing with global credits. This is a positive development because it was difficult to arrange deals with exclusively Asian names as the reference entities. Most of the Asian bonds do not have credit default swaps attached to them because they are not very liquid. There wasn't the diversification that you would get with a global portfolio, and there was difficulty in finding enough good quality names as the Asian cash bond market is still relatively small.
Why is it that nearly all the Asian deals seemed to be managed by Singaporean asset managers?
Cheng: The portfolio managers in Singapore have perhaps been more active in looking at this product as they seek to expand their sources of revenue. You may also attribute this trend to the government, who has been very active in promoting the development of the capital markets in Singapore. But it should be pointed out that Hong Kong portfolio managers have also been involved in CDOs. Last year, PCI worked with Lehman Brothers on a deal. We have also seen portfolio managers from China becoming involved with this product, so the activity is extending into other parts of the region. What we are seeing is that as portfolio managers become more familiar with the operation of CDS and CDOs, their interest will increase, and I believe we will see growth in other jurisdictions.
How do synthetic deals differ from cash securitizations in terms of structure?
Cheng: With some of the Asian cash flow deals, the underlying assets have been rated at the non-investment grade level, so the deals required a high degree of subordination, perhaps as much as 20%, to secure better ratings. There is more leveraging with synthetic CDOs. Usually they have a very big portfolio with 100 or more names and the subordinated equity piece is usually very small - between 3% and 5%. Arrangers try to compress the excess spread in the transaction to provide sufficient returns for the holder of the equity piece. The reason that the subordination is much lower is due to the quality of the portfolio. You normally have a minimum eligibility criterion of Baa3 for any one credit and it is not unusual to find the average rating in the portfolio of Baa1 or A3. The diversity is much higher as well and you also have a huge unfunded super senior piece. You only have to sell the mezzanine tranches, so it is a little easier to find investors.
Within the synthetic CDO world there are two structural variables: whether you do deals with or without excess spread. Most of the deals have been done without excess spread and you have subordination of between 3% and 5%. But more recently, we have seen deals completed with excess spread features. As time goes by, you build up credit support to the mezzanine tranches as well.
The balance sheet CDO market has not taken off in Asia in the way it was hoped. What are the main reasons for this?
Cheng: There have been a couple of balance sheet deals in the past in Asia. ABN Amro did a synthetic MBS transaction and DBS issued a synthetic CLO deal. It is important to look at the underlying reasons for banks to do balance sheet deals. At the moment, the loan market is still very competitive. If you securitize, the loan book may reduce and the bank has to try and acquire new assets. From the bank's perspective, the cost of funding is still very low. When banks think about synthetic securitization, the main motivation is risk management and getting regulatory capital relief.
That is true, but given the need to achieve better capital adequacy ratios because of Basel 2, isn't it still surprising that more banks haven't attempted to do deals?
Ye: I guess the majority of banks that may look at synthetic deals would be concentrated in Hong Kong and Singapore. At the moment, they are very liquid and their capital adequacy ratios tend to be quite high already. So with regards to meeting Basel I and II requirements, there is no urgency for them to do deals at the moment. The motivation would have to come from their internal risk-management or balance-sheet needs. As far as banks in other jurisdictions are concerned, the urgency to do this may be present, but perhaps they aren't savvy enough to fully understand how synthetic CDOs can help them in this regard. It may also be the case that there may be legal and regulatory impediments to doing deals in certain jurisdictions.
However, given how the CDS market has deepened in the region over the past three years, banks have become more exposed to that - not just the treasury departments which trade these products, but the banks have also invested in CDOs. So the awareness and understanding of synthetic products is increasing, and they may look to transfer the technology in order to improve their management of their balance sheets. These deals will happen - it has been slower than maybe we anticipated, but it will come.
If the regional economy picks up, the banks will have greater capital requirements for financing new assets. In the last few years, there has been a limited need for new financing and no real need for them to shed existing assets. But if China opens up, for example, banks may start investing there and may need to offload some assets to get the cash to buy new assets. An upturn in the economy should result in more of these balance sheet-type transactions.
What do you see as the main benefits of balance sheet CDOs to financial institutions?
Cheng: Risk management is one of the main reasons banks would do deals: there may be certain assets where they would like to divest some of their risk. On top of that, you have the Basel I and II regulatory capital requirements. For example, some of the global banks with offices in Asia have already done deals for this reason already - packaging loans from many regions together into one deal.
How have the existing CDO transactions performed?
Cheng: The performance has been very good in general. We did put a transaction on review for possible downgrade about a month ago, but the portfolio manager rebalanced the portfolio so we were able to confirm the rating.
If you were to compare the credit quality of the portfolio today with what it was at the time of origination, overall it may have deteriorated slightly, but that is why transactions have certain cushions built in to withstand credit pressures. The current ratings will still stand unless it further deteriorates.
Ye: If you compare the Asian high yield CDOs with US high yield CDOs, the Asian deals are doing OK because we have not seen a massive credit deterioration, unlike the US deals. The cycle is a bit different - we haven't seen the same level of downgrades on Asian credits.
The deal that we put under review did have quite a high exposure to European and US credits and downward movements on some of those credits did put the deal under pressure. But the portfolio manager sold its position on some credits and replaced them by taking other positions. That shored up the credit quality of the deal.
