Institutional Investor's Alpha Magazine - February 2008 - (Page 56)

Unhedged Commentary Structured for Success By Brian James and Joseph Messineo on’t write off securitization just yet. The technology for creating collateralized debt obligations has existed for more than two decades. It has been used to securitize senior secured bank loans, subprime residential mortgages and just about everything in between. As a result, CDOs are no strangers to boom-and-bust cycles. But as the fallout from the collapse of the subprime mortgage market continues to shape choices on Wall Street, opinion remains split on the virtues of CDOs. Proponents argue that the positive effects of securitization on capital formation, diversiﬁcation of risk and the ability of issuers to fund assets to term outweigh the complexity of CDOs and the mistakes they can conceal. What cannot be disputed about CDOs is their relevance. Annual issuance ballooned from $82 billion in 2003 to $450 billion in 2006, with most of the growth coming from the resecuBanks, not hedge ritization of existing subprime securities. Although many factors drove funds, got caught the most recent debacle, subprime mortgages themselves may not be holding the at the top of the list. Contrary to bag when the CDO popular wisdom, subprime loans were far more an effect than a cause market collapsed. of the crisis. Flaws in the design of many Wall Street structured-credit Savvy managers businesses were really to blame. can capitalize Large banks, flush with capital from a prolonged bull market, on their troubles. found it expedient to retain the securitized paper they created instead of taking the more traditional investment banking approach of repackaging and selling the risk. These banks became their own best customers. In a race to the top of the CDO league tables, they drove spreads tight and pushed many traditional investors out of the CDO market. At the height of new issuance, most hedge funds simply said “no thanks” to residual (last cash ﬂow) tranches where in some cases leverage was more than 150 times the underlying capital and the risk-return proﬁle was a 100 percent potential loss, with a maximum return of perhaps 14 or 15 percent. Another problem was the undiversified nature of these CDO businesses. Instead of warehousing, arranging and then selling deals across multiple asset classes (commercial real estate, investment-grade corporate debt and leveraged loans), many banks decided to focus D on only CDOs of subprime asset-backed securities, as these trades were the fastest to execute. The good news for hedge funds and other investors is that opportunities abound within the CDO and structured-credit markets. There is roughly $1 trillion of cash CDO notional outstanding and more than $3 trillion in total in securitizations, with a signiﬁcant portion held on the books of banks and the structured investment vehicles they control. So far, much of the recent activity in the CDO market has been in the form of write-downs. But after the $146 billion of write-downs, banks will eventually be forced to sell CDO securities and liquidate their underlying assets in cases where there are events of default. Although headlines continue to focus on housing and subprime asset-backed securities, the best opportunities may be in far different areas. Subprime credit issues have led to major dislocations in other markets. The leveraged-buyout market has relied heavily on the collateralized loan obligation market for funding through the bull market credit cycle. New CLO issuance, however, is now almost nonexistent and the effects of that are signiﬁcant. The LCDX 9 (an index of 100 syndicated secured loans) widened 150 basis points in January. The commercialmortgage-backed-securities market is also feeling the effect. The most current BBB– tranche of the CMBX (an index of CMBS deals) widened 379 basis points in January. Most dealers still have an overhang of deals that they cannot sell. Hedge funds should take note of the problems that have resulted from banks’ undiversiﬁed approach to their own structured-credit businesses. Although it may be proﬁtable for a manager to hire a team dedicated solely to ﬁnding opportunities in the subprime market, what will happen in two or three years when that trade has dried up? The funds that create the most alpha over the long term will need to have the expertise and capital to analyze and move among various asset classes within structured credit. That requires analysts and portfolio managers who understand the structural idiosyncrasies of the market and can develop models to exploit them. This, in turn, means a greater commitment of human capital, something lost in the most recent credit bull market. Brian James and Joseph Messineo are partners at Link Global Solutions, a New York–based recruiting and consulting ﬁrm. From 2002 to 2007 they were co-heads of ﬁxed income at structured credit ﬁrm Cohen & Co. 56 • INSTITUTIONAL INVESTOR’S ALPHA • FEBRUARY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - February 2008

Institutional Investor's Alpha Magazine - February 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Alternative Perspective The Good Guys: A Simple Plan Cover Story: Energy and Commodities: Fueling Opportunity Regulation: Energy Trading: The Brawl on the Hill Interview: Master of Values Regulation: Hedge Fund Registration: Way Out West Research Center: Top Hedge Fund Analysts Alpha Bytes: Rocket Man Unhedged: Commentary: Structured for Success

Institutional Investor's Alpha Magazine - February 2008

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