Creditflux Newsletter

Something amazing happened recently: there was a CDO auction, and hundreds of traders turned on, tuned in, and didn’t drop out

Something happened a few weeks ago that may come to be seen as a turning point for the credit market. A group of slightly ragged individuals came together somewhere in a far flung upstate part of the online world and partied.

Those who are old enough – and who weren’t too far out of it at the time – may recall a similar event in 2003. Then, the high yield bond market had suffered two years of heavy defaults and CBO issuance had dried up. But a UK second-tier bank staggered in bearing copious amounts of yield-altering substances.

Abbey National had decided to sell its structured credit book. Even back then, this was nothing new. Investors had been stampeding for the exit for the past 12 months. But for some reason, maybe it was timing, maybe the vibe was just right, or – most likely – the stuff was so damn cheap, that Abbey National’s decision to sell was a turning point.

Through an auction process organised by Pimco (an early example of the latest trend of asset manager-turns-broker), the heavy supply of Abbey CDOs whetted the appetite of buyers. That encouraged more sellers into the market. And, for a while, there was a thriving secondary market in CDOs. The market started to figure out what risk was worth and that encouraged issuance of corporate debt.

Last month’s auction of assets from the Whistlejacket SIV may be similarly historic. Until now, the secondary market for CDOs has been stalled. There is plenty of capital for distressed assets, but buyers have been holding out for better terms. The banks that are the big holders of CDOs have been keeping an eye on the bids, but haven’t liked what they’ve seen. They would rather mark their assets using internal models than crystallise a bigger loss by selling to distressed funds.

The market needed an Abbey – a seller in size that would force buyers off the sidelines. With few banks willing to sell at the moment, the only big sellers are the busted structured credit investment vehicles – SIVs and CDOs of ABS. There have been big auctions before of these portfolios, but none have had the success of Whistlejacket.

The auction not only produced higher prices than anyone had been expecting – especially for senior CLO bonds – it also brought a much greater number of participants into the market. There is strong anecdotal evidence of widespread involvement. Usually, we need to hunt high and low to find anyone who was actually involved in a CDO auction. But, with Whistlejacket, almost everyone we meet says they either put in a bid or handled some trades.

It was a distressed fest. Rather like Woodstock, if you weren’t there, you will end up claiming that you were.

You may dismiss Whistlejacket as a bunch of traders getting overexcited at the top of a suckers rally. And certainly, the spring rise in the market generally helped bring out the bids. (It may also have helped that this auction was better organised and better thought out than previous liquidations.)

But we think that the success of the Whistlejacket auction was more than simply a reaction to improved market sentiment. Hopefully, it marks a real boost to the secondary CDO market, one that will survive the inevitable resumption of spread-widening. That is because assets are being priced in bigger quantities than before and at more visible levels. Unlike Woodstock, Whistlejacket will force institutions to sober up.

Banks that continue to mark their mezzanine CDOs at 50 have nowhere to hide. That is good for building lasting stability in the global financial system.