Banks

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Economy

Draghi: Eurozone will decline without vital productivity growth

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Currencies

Asia markets tentative ahead of Opec meeting

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Banks, Financial

RBS emerges as biggest failure in tough UK bank stress tests

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Banks

Barclays: life in the old dog yet

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Categorized | Banks, Capital Markets, Property

Investors enliven second generation CDOs


Posted on January 31, 2013

Whatever you do, don’t call it a collateralised debt obligation. If Wall Street never sees the letters C, D and O side by side again, it will be too soon.

These financial instruments, built out of other financial instruments built out of mortgages that no one could afford, poisoned the banking system. As, of course, you will have heard.

    Click to enlarge

    Except that not all CDOs were built out of trash, and a handful of the less dizzyingly complex ones in fact performed OK through the financial crisis. After a decent interval, CDOs look to be coming back as a means of funding for commercial property.

    The area of revival is narrow, and the experiment so far is small. Royal Bank of Scotland identified five deals in recent months with CDO-like characteristics, built out of mortgages on commercial real estate (CRE). The development was enough to make Richard Hill, strategist at RBS, exclaim: “It’s alive! Call us, Dr Frankenstein.”

    That was the headline in Mr Hill’s note to clients. In fact, he sees nothing monsterish in the revival, and every reason to treat these latest issues seriously.

    “The business we used to call CRE CDOs should have done a better job of differentiating between different classes of deals,” he says. “CRE CDOs was a big umbrella. The differentiating part is the collateral. These new issues have taken very strong steps not to call themselves CDOs, and that is fair.”

    So what has come on the market? Several offer just a modest twist on traditional commercial mortgage-backed securities, which are bonds backed by a defined pool of commercial property loans. Three of the deals were collateralised with loans that are too risky for traditional CMBS, either because they are mortgages on recently refurbished properties or risky mezzanine loans that have to wait in line behind first-lien mortgages to get paid in a bankruptcy.

    But Arbor Realty Trust last September became the first manager since the crisis to issue a full-blown collateralised loan obligation, a kind of CDO, where investors do not have a full picture upfront of which commercial mortgages would go into the pool. It raised $125m for a deal giving it flexibility to invest some of the money into loans of its choosing.

    Investor reaction was positive enough that Arbor closed a second, $260m deal this week, for which it did not have to offer as big a premium over Treasury yields.

    “These deals are consistent with a market where rates are very low and spreads have tightened considerably,” says Franco Castagliuolo, a portfolio manager at Fidelity Investments. In other words, investors will find the additional complexity and risk is worth it, if the deals offer better yields than those available elsewhere.

    The re-emergence of CDO-like structures in commercial real estate is perhaps inevitable, since traditional CMBS now yield just 1.3 percentage points more than Treasuries, according to Barclays. Spreads have not been this tight since before the US property market began heading south in 2007.

    Fidelity has not bought any of the new-generation CDO-like securities, but in common with a lot of sophisticated investors over the past year, it has been buying up some of the pre-crisis CDOs when they have fallen to attractive levels.

    The five deals on the RBS list of CDO-like investments total little more than $1bn so far, compared with a traditional CMBS market that roared back to $48.4bn in new issuance last year. No one is forecasting a return to the pre-crisis era when CRE CDO issuance peaked at more than $60bn in 2006.

    Neither is anyone predicting a return to a time when investors around the world were clamouring for CDOs made out of a ragbag of risky assets, including non-standard loans, equity tranches of CMBS and even pieces of other CDOs, all curated by a CDO manager with wide latitude to choose the investments it wished.

    In one deal that does echo that phenomenon, Deutsche Bank recently created an internal CDO that bundled pieces of old CDOs and other assets, so as to sell a €110m slice of the risk, but that was a bespoke deal for a single client.

    In the commercial real estate space, “banks are going to be reluctant, since regulators are wanting them to return to a much more simplistic model, and it will be difficult to gain support from an issuer and an investor perspective”, says Mr Hill.

    “But,” he adds, “there is a real place in CRE finance for a return to CRE CDOs backed by simple, safe first mortgages.”