SF CDOs may be managed or static. In 2003, approximately 75% of cash and 60%
of synthetic transactions were managed. As a general rule, managed transactions are undertaken for the purposes of exploiting an arbitrage opportunity and generating fee income for the manager. In contrast, static transactions may be a funding vehicle or balance sheet management tool for the issuer.
In managed deals, asset managers are typically allowed a 10-20% annual trading bucket as long as certain collateral quality tests are met (O/C, I/C, WARF, various concentration tests). Most deals have a reinvestment period of 3-5 years, after which discretional trading eliminated. Managers often have some flexibility (irregardless of reinvestment period or collateral quality tests) to sell defaulted and credit risk securities at any time. This flexibility is sometimes extended to credit improved securities.
Senior management fees (paid at the top of the cashflow waterfall) are typically 10-20bp. Subordinate management fees (paid at the after rated notes) are typically 20-30bp. Both senior and subordinate fees have been falling for the last several years.
In addition to holding a portion of the equity tranche, managers may also retain an incentive management fee equal to a percentage of excess cash flow after the equity tranche has received a benchmark return.
Although static transactions are not actively managed and have no reinvestment period, issuers may have the ability to substitute credit improved and/or distressed securities. In addition, issuers are responsible for the selection and/or origination of the original collateral pool. Static transactions feature reduced management fees.
Unmanaged transactions have no reinvestment period, so senior noteholders may have shorter weighted average lives (and corresponding reinvestment risk) due to prepayments and natural amortization of the collateral balance. We feel compelled to note that there exists a potential for issuer moral hazard here, whereby the issuer includes less-desirable assets than they are willing to hold on their own balance sheet. As always, investor caution and appropriate due diligence is key. Ultimately, balance sheet deals are probably more appropriate for investors with some
experience in the underlying assets that are able to carefully examine the pool without relying on an asset manager.
Below, we explore several asset manager considerations specific to structured product collateral.
Liquidity and Transparency. Structured products are typically less
liquid/transparent relative to the corporate market. As such, managers have an increased opportunity to add alpha. In addition, there is significant price tiering among structured product issuers. Managers can also add alpha by selecting cheaper non-benchmark names. On the other hand, managers are somewhat restricted from active management due to the detrimental effect of crossing the (higher) bid/offer. Although the bid/offer spread is lower for senior structured Managed Transactions
Static Transactions
Special Considerations
products tranches, the impact of crossing the bid/offer on excess spread is magnified because of the lower excess spread and higher leverage in these deals.
Contagion Risk. Structured products are exposed to contagion risk, and securities with performance problems may exhibit negative momentum. Sectors with negative momentum benefit from active asset management, which can help minimize losses.
Table 20 below shows 1-5 year cumulative material impairments for BBB structured products and corporates based on their original rating (at issuance) and cohort rating (at the start of the year, may be lower or higher than original rating). The table shows that material impairment rates for structured products are higher by cohort rating across all time horizons. The difference suggests that securities that have been downgraded to BBB from a higher rating (as shown by the cohort rating) fare worse than securities that were initially rated BBB. This momentum effect is not apparent in corporates.
Table 20
Cumulative Material Impairments for All BBB Securities by Cohort and Original Rating
Year 1 Year 2 Year 3 Year 4 Year 5
Structured Finance
Cohort Rating 0.99% 2.53% 5.01% 6.49% 8.36%
Original Rating 0.26% 1.09% 2.27% 3.33% 3.87%
Corporate
Cohort Rating 0.44% 0.95% 1.52% 2.21% 3.06%
Original Rating 0.58% 1.20% 1.86% 2.78% 3.87%
Source: Moodys.
Delayed rating actions on structured product collateral. Rated noteholders depend on credit enhancement derived from the O/C tests, which divert excess cashflows in the event of collateral deterioration. Collateral, however, is held at par value or a haircut par value (e.g. sub-investment grade bucket) for the purpose of the O/C tests. This means that distressed collateral that is still investment grade will still be given full credit for the purposes of the O/C tests. This methodology is particularly problematic for structured products, where rating actions often severely lag the market developments. Asset managers can enhance rated-note stability via proactive management of the collateral pool before a downgrade occurs (realized losses are reflected in O/C tests).
Programmatic Issuers. In both managed and unmanaged transactions, the selection of the issuer/manager is critical. Investors (especially those with limited structured products credit expertise) should favor high-quality programmatic
issuers with a long-term commitment to the market. These issuers have an interest in preserving their reputation, as well as a visible track record, which minimizes any moral hazard in portfolio selection. In addition, programmatic issuers are familiar to the market, which increases liquidity of their notes. In some cases, because the SF CDO market is still relatively young, good managers of underlying structured
products are just now bringing their first SF CDOs. In these cases, it is especially important for investors to carefully evaluate the managers infrastructure and long-term commitment to the market. Infrastructure is particularly important due to the complexity of the collateral.
Table 21 below provides information on 37 managers of 58 SF CDOs issued between 1999 and 2002 for which Moodys provides performance data. Although Moodys data does not cover the entire issuer universe (e.g. it is only US), it does provide some of the more detailed performance measures available, these measures are briefly described below. It is important to note that these metrics measure performance on what we have referred to as first generation SF CDOs. Many lessons have been learned from the experiences. See Appendix C for a listing of seasoned SF CDO managers (managers with two or more deals in the last two years); this list includes some European managers.
Moodys Deal Score (MDS)
MDS measures changes in expected loss for tranches that were originally rated investment grade. When current deal ratings deteriorate (expected loss increases), the MDS increases.15 Although ratings may lag performance, they can be a good indicator of manager ability over the long run.
Annual Loss or Gain of O/C
O/C is a measure of current collateral value relative to current liabilities. The O/C calculation measures most collateral at par value. Exceptions include defaulted securities (measured at lesser of market value or recovery rate). The table shows the annualized percent change in O/C. Negative numbers indicate that O/C is increasing.
Weighted Average Rating Factor (WARF) Cushion
WARF is an indicator of collateral pool risk. Higher rating factors indicate lower average collateral ratings. Cushion is the amount by which current levels exceed test levels imbedded in the deal. A negative cushion indicates that a deal is in violation of its test levels. Management flexibility is generally restricted following a breach of test level.
Quantitative Manager Analysis
15. See Moodys Publication CDO Rating Methodology: Moodys Deal Score, February 2003, for more information.
Table 21
Moodys SF CDO Asset Manager Analysis16
Current Average Annual Current Moodys
# of Moody's Deal Loss/Gain WARF
Collateral Manager Deals Score (MDS) of OC Compl./Violation
Alliance Capital Management L.P. 1 0.00 -0.02% 5.62%
Asset Allocation & Management Company 1 2.29 -0.48% -191.65%
Beacon Hill Asset Management, L.L.C. 2 0.91 0.20% -102.43%
Capital Guardian Trust Co. 1 0.00 0.37% -20.32%
Clinton Group, Inc. 2 0.00 -0.37% -7.40%
Coast Asset Management, L.P. 1 0.00 0.37% -17.21%
David L. Babson & Company Inc. 1 0.00 -0.04% -8.49%
Deerfield Capital Management LLC 3 0.11 0.74% -86.61%
Duke Funding Management , L.L.C. 1 0.00 -1.37% -78.16%
Ellington Capital Management 2 0.00 -0.57% -10.59%
Fischer Frances Trees & Watts, Inc 1 0.00 -0.01% -37.75%
Fortress Investment Corp. 1 0.00 0.23% 22.78%
General Re-New England Asset Management, Inc. 1 0.00 -0.40% -29.34%
HarbourView Asset Management Corporation 1 0.00 0.79% -109.87%
Hyperion Capital Management Inc. 1 0.32 0.52% -79.85%
Independence Fixed Income Associates, 3 0.11 -0.86% -54.83%
ING Baring (US) Capital Corporation 2 0.00 -0.11% 13.30%
Lord, Abbett & Co. LLC 1 0.00 -0.62% 2.49%
Metropolitan Life Insurance Company 1 0.00 0.89% -18.66%
Metropolitan West Asset Management, LLC. 1 0.55 0.54% -55.97%
MKP Capital Management, L.L.C. 2 0.00 -1.37% -135.24%
MONY Life Insurance Company 2 0.00 -0.64% 28.31%
New York Life Investment Management LLC 1 0.00 0.40% -16.25%
Newcastle Investment Corp. 1 0.00 -0.39% 23.25%
Pacific Investment Management Company 2 0.00 -0.11% -3.18%
Phoenix Investment Counsel, Inc. 1 2.26 0.40% -146.77%
PPM America Inc. 1 2.28 0.04% -309.14%
Putnam Advisory Company, Inc. 2 0.00 -0.32% 9.82%
RWT Holdings, Inc 1 0.00 1.12% 7.74%
State Street Research 1 0.00 -1.14% 16.90%
Structured Finance Advisors, Inc. 2 1.48 0.68% -67.76%
TCW Asset Management Company 4 0.00 -0.38% -30.30%
Teachers Ins. and Annuity Assoc. of America 1 0.00 -0.05% -83.59%
Wells Fargo Bank, N.A. 1 0.00 0.48% -0.02%
West LB 4 0.06 0.17% -5.01%
Western Asset Management Company 3 0.65 0.30% -135.52%
ZAIS Group Inc. 1 0.00 1.60% 12.35%
Source: Moodys Investors Service.
16. Moodys Deal Score Report, Moodys Investor Service, January 2004.