CDOs Flicker to Life With Babson, Deutsche Takeovers

Date: Thursday, May 15, 2008
Author: Neil Unmack and Pierre Paulden, Bloomberg.com

Collateralized debt obligations, the securities that contributed to $323 billion of bank writedowns, 65,000 job losses and the collapse of Bear Stearns Cos., may be staggering back to life.

Babson Capital Management LLC took over a $680 million CDO from Hartford Financial Services Group Inc. this month, adding to the $22 billion of the securities it oversees. Deutsche Asset Management replaced London-based Brevan Howard Asset Management LLP on a CDO in April. Blackstone Group LP, the largest buyout fund operator, sold three CDOs totaling $1.3 billion in April.

The combination of takeovers and new funds signals a new stage of the global credit crisis as CDO managers vie for more than $2 billion in annual fees generated by the market. One in five managers of the funds that pool bonds, loans and other assets face ``financial stress'' or ruin, according to Fitch Ratings.

``We absolutely believe the market will come back,'' said Matthew Natcharian, 39, managing director for structured products at Springfield, Massachusetts-based Babson, a unit of MassMutual Financial Group. ``We're actively looking for opportunities,'' said Natcharian, whose firm also invests in private equity and emerging-market bonds.

In much the same way BlackRock Inc. Chief Executive Officer Laurence Fink stepped in at the Federal Reserve's request to manage $30 billion of hard-to-sell assets from Bear Stearns and agreed to take on $15 billion more for UBS AG, firms in the CDO market with the resources to sit out the credit crunch now find themselves in demand.

Drexel's Creation

CDOs pool assets from mortgage debt to currency options and turn them into bonds that are sliced into portions of varying risk and sold to hedge funds, pension funds and other investors.

Drexel Burnham Lambert Inc. created CDOs in 1987 at the height of the boom in junk bonds, the high-yield, high-risk debt ranked below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's.

The securities became the epicenter of subprime turmoil because they repackaged mortgage loans to people with poor credit into securities that received AAA ratings.

UBS increased investments in CDOs as well as selling them to clients over the past three years. By September, the Zurich- based bank accumulated $50 billion of holdings of the securities based on subprime mortgage debt. The CDO portions UBS held were so-called super-seniors, the last in line to be affected by losses.

Worst Writedowns

The CDOs accounted for 50 percent of the $18.7 billion of subprime losses last year at UBS, contributing to the worst writedowns for a European bank. Decreases in the value of loans to finance the securities produced a further 16 percent of the company's losses, according to an April 28 report.

Rowan Staines, a spokeswoman for UBS in London, declined to comment on the report.

Wall Street is eliminating 65,000 jobs in part to compensate for a drop in sales and trading of asset-backed securities and high-yield corporate debt.

Sales of CDOs have slumped to $23.3 billion this year from $207 billion in the same period of 2007, according to Morgan Stanley data.

``Some are likely to have to exit the business or merge,'' said Ashish Keyal, who analyzes CDOs at Lehman Brothers Holdings Inc. in London. ``Many first-time managers that only have one or two CDOs will find it very difficult to do new deals.''

Babson's Deal

The takeovers of competitors' CDOs resemble the consolidation of the $11.7 trillion U.S. mutual-fund industry since the 2001 stock-market decline. AMR Corp., the parent of American Airlines, said last month it was selling 90 percent of American Beacon Advisors Inc. to Lighthouse Holdings Inc., owned by TPG Capital and Pharos Capital Group LLC, for $480 million. American Beacon manages $65 billion including mutual funds.

Babson took over supervision of a CDO from Brightwater Capital Management, a unit of Dusseldorf-based WestLB AG, in February. Investors in Hartford's Beecher Loan Fund picked Babson and renamed the CDO Vinacasa after the value of the leveraged buyout loans it held dropped below 90 cents on the dollar in February, Natcharian said.

In addition to replacing Brevan Howard, Deutsche Asset, a unit of Germany's biggest bank, has also won roles to advise holders of collateralized debt obligations and other asset- backed debt, said Joern Wasmund, the Frankfurt-based head of CDOs for Europe and Asia.

Annual Fees

CDO managers earn annual fees ranging from 0.15 percent to 0.65 percent, Wasmund said. Fees on CDOs of leveraged loans, known as collateralized loan obligations, or CLOs, average about 0.5 percent of assets annually, or $2 billion based on the $400 billion outstanding, Lehman data show.

Thirty CLO managers are likely to close or put their $15 billion of funds up for takeover, according to Lehman.

Firms need to manage at least three CDOs of about $600 million each to break even, according to Fitch estimates based on deals packaging European leveraged loans.

While CDO firms are starting to revive sales of securities backed by leveraged loans, the market for deals comprising mortgage and other asset-backed debt has been closed since 2007. Sales of the securities totaled more than $144 billion last year, according to JPMorgan Chase & Co. data.

``We don't see any revival for CDOs backed by asset-backed debt,'' said Natcharian. ``We do expect to see CLOs come back, although investors will be much more discriminating.''

Babson oversees 55 CDOs, including 25 based on $16.5 billion of leveraged loans, Natcharian said. The firm largely avoided subprime mortgage securities, he said.

`Threat and Challenge'

Babson and Deutsche Asset don't disclose revenue from their CDO businesses. Managers of the securities typically invest in the ones they oversee, often holding the riskier parts, according to Fitch.

The sales decline is ``a threat and a challenge,'' said Wasmund, whose firm is owned by Deutsche Bank AG and oversees $30 billion of CDOs. ``Some of your business opportunities are falling apart, which is a problem. But the established managers can cope with this problem because they already have a significant amount of assets under management and the infrastructure in place to manage them.''

Cairn Capital Ltd., a London-based manager of $10 billion of assets, replaced hedge fund Sailfish Capital Partners LLC on a $1.2 billion CDO last month after the Stamford, Connecticut- based company began winding down its business following investor redemptions from other funds.

Carlyle Group

Avoca Capital Holdings, a Dublin-based manager with about 4 billion euros ($6.2 billion) of assets, raised 300 million euros last week for a CDO of European leveraged loans arranged by Credit Suisse Group.

Carlyle Group, the world's second-biggest private-equity firm, is selling a $500 million CDO of loans arranged by Deutsche Bank. The Washington-based buyout firm run by David Rubenstein also raised a $450 million fund last month.

Carlyle and Blackstone provided capital for the equity portions of the deals, according to marketing documents. The three CDOs Blackstone created in April were made up of loans and were sold through its GSO Capital Partners unit.

``If a manager wants to do new CDO deals, they are going to have to commit a substantial amount of their own capital,'' said Brian James, a partner at Link Global Solutions, a New York- based structured finance consulting and recruiting firm. ``Certainly the market isn't dead.''

To contact the reporter for this story: Neil Unmack in London nunmack@bloomberg.net; Pierre Paulden in New York at ppaulden@bloomberg.net