'Out of CDOs': New Age Finance's Alternative Reality

by: Michael Panzner

In “Futures to Surpass Bonds as Appetite for Risk Rises,” Bloomberg reports on a development unlikely to surprise those who’ve been following the rapidly growing interest in new age finance's alternative reality.

Treasury futures, the most-active contracts on the Chicago Board of Trade, may surpass trading in notes and bonds for the first time next year as money managers use more derivatives to boost returns.

A record 60.5 million contracts changed hands in February, the equivalent of $6.62 trillion of Treasuries. Wall Street's biggest firms handled about $9.57 trillion of bonds, according to Federal Reserve data. Futures more than doubled in the past five years and, at the current pace, will overtake trading in the cash securities during 2008.

“Fund sponsors who had in the past not allowed investment managers to use derivatives are more eager to do so,'' said Greg DeForrest, senior vice president at Callan Associates in San Francisco. The second-biggest adviser to U.S. pension funds has about 266 clients with a combined $1 trillion of assets.

Almost all of Mellon Capital Management's customers for global asset-allocation products allow the money manager to use derivatives, up from 64 percent of assets in 2003 and 10 percent in 1999, spokesman Mike Dunn said. The San Francisco-based company is buying futures, providing more cash for investment in stock, bond and currency derivatives.

Mellon clients that used futures got returns that averaged 17.3 percent a year between 1989 and 2005, compared with 13.7 percent for those who didn't, according to a review by Chief Executive Officer Charles Jacklin. Mellon managed $32.9 billion in so-called tactical asset-allocation funds as of the end of 2006.

'Catching Up'

Efforts to boost returns “have really made futures much more valuable than cash bonds,'' said William Hoskins, Mellon's director of fixed-income research. Futures costing $500 to $1,485 allow investors to capture price changes on $100,000 of underlying five- to 30-year Treasuries or $200,000 of two-year notes.

A survey by Russell Investment Group, the largest adviser to U.S. pension funds, found 87 percent of its clients allow money managers they hire to use derivatives. While there wasn't an earlier survey, “anecdotally my sense is it's increased,'' said Jeff Hussey, head of U.S. fixed income at Russell in Tacoma, Washington.

“Fixed-income managers are catching up to what hedge funds have to offer,'' said Hussey. More managers are aiming, with the aid of derivatives, to beat a benchmark by 2 percentage points annually, double the typical objective, he said….

Lagging Returns

Low bond yields are encouraging pension funds and other investors to take more risks in order to meet their targets for returns, Hussey said.

Given the investment climate of the past few years, it's no wonder that Wall Streeters have been thinking -- and acting -- this way. Fierce competition, asymmetric compensation incentives, and a seemingly never-ending gusher of debt-based liquidity have encouraged many of today’s movers-and-shakers to swing for the fences in all sorts of exotic and dangerous markets.

Still, one might have thought some recent developments would have spurred investors to be a bit more cautious about rushing headlong into the nether world of synthetically-created securities.

Consider, for example, a just-released report from ratings agency Fitch. If you look past the mind-numbing mumbo-jumbo, “Fitch: Subprime Woes Extend to 2006 & Earlier Vintage SF CDOs” clearly suggests that the infection in subprime lending is spreading to derivatives such as Collateralized Debt Obligations, which are convoluted constructs concocted from subprime mortgages and other dodgy assets.

As the U.S. subprime market stresses continue to materialize, 2005 and 2006 vintage structured finance (NYSE:SF) CDOs will be under greater ratings pressure as they have substantially larger concentrations of subprime RMBS, according to Fitch analysts in a new report. Ratings volatility arising from later vintage subprime RMBS will likely be experienced in 12-18 months as the actual loss experience becomes clearer, according to Senior Director Derek Miller.

'Though 2006 performance will be very poor, Fitch's more immediate concerns focus on near-term ratings volatility that will arise from earlier vintage subprime RMBS,' said Miller. 'Negative selection among borrowers due to prepayments is occurring simultaneously with the release of credit enhancement due to RMBS performance triggers passing, against the backdrop of a slowdown in the U.S. housing market.'

Mezzanine SF CDOs have the highest credit exposure to subprime RMBS through subordinate bonds (rated 'A' and lower) and appear to be most vulnerable, according to Fitch's study. More than 220 Fitch-rated high grade and mezzanine SF CDOs have exposure to U.S. subprime RMBS bonds, with U.S. CDOs averaging 44.7% exposure (compared to 22.7% for European SF CDOs). Of the 137 Fitch-rated SF CDOs currently with exposure to mezzanine subprime RMBS, 95 were issued in 2003 or after, with average exposure ranging from 43.3% to 71.3%

Approximately 3.2% of 2003 to 2006 vintage mezzanine SF CDO portfolios are comprised of below investment grade subprime RMBS, and 16% 'BBB-' assets. These RMBS assets, according to Senior Director Grant Bailey, 'are most at risk for default or downgrade due to their position in the capital structure.'

Fitch will address subprime RMBS exposure of synthetic SF CDOs in a separate report to be released in the near future. 'Rating Stability of Fitch-Rated Global Cash Mezzanine Structured Finance CDOs with Exposure to U.S. Subprime RMBS' is available on the Fitch Ratings web site at www.fitchratings.com.

Others are making the case more forcefully. In “F&C Says CDO Market to See 'Massive Default Cycle,’” one money manager takes a much less obfuscatory line in describing the dangers that lie ahead in this not-so-little corner of the derivatives universe.

A massive wave of defaults is set to hit the CDO… market following the sub-prime mortgage meltdown in the U.S., although this could take a year to play out, a fund manager told Reuters.

Francois Barthelemy of F&C Partners, which is part-owned by F&C Asset Management, said that as a result he has increased exposure to hedge funds which he believes can exploit distressed debt situations to 20 percent of his portfolio from 10 percent a year ago.

"I do think a massive default cycle is about to start in the CDO market. It's mad. Sub-prime will create massive defaults," he told Reuters in a recent interview.

CDOs package assets such as bonds, loans and asset-backed securities together and then issue notes backed by the assets; they are similar to mutual funds in packaging securities to help diversify risk.

Much of the risk from the U.S. sub-prime mortgage market, which has seen rising default rates in recent months amid falling prices and slower sales in the housing market, has been farmed out in securities such as CDOs, which Barthelemy believes will be vulnerable.

"The event that will destroy the CDO market has already happened. But it will take another year to trickle down. They (the holders of the CDOs) don't realise what's going to happen," he said.

"I'm playing it by being out of CDOs and putting money into distressed investors who can restructure those CDOs."

No doubt some will say that any comparison between exchange-traded futures and the over-the-counter derivatives markets is unfair, because the former is more liquid, better regulated, and more transparent -- less risky, in other words.

That's funny, I seem to remember proponents arguing up to a short while ago that the CDO market was a very safe place to invest.

I guess they were mistaken.