Creditflux Newsletter

Politicians and regulators often attack credit default swaps as being secretive, illiquid and opaque. Shhh! Don’t tell them about the secondary market for CDOs. Forget the debates about whether products should be traded on an exchange or through a central counterparty. Secondary CDO trading has only barely graduated to email.

Here is how the market works. First the seller, let’s assume it is a European insurance company, gets in touch with a broker. They do not find the broker in the yellow pages. Instead the guy who runs the legacy portfolio at the insurance company calls a guy he used to sit next to at an investment bank who later sold him CDOs when he went to a now defunct CDO-squared shop.

Between them they figure out a reserve price for a list of about 20 bonds. This is the bid-wanted-in-competition or b-wic or simply the bid list. The broker then breaks the list down into several parts – perhaps one for (originally) triple A CLOs, one for CLO mezz and one for the two CSOs that the former portfolio manager was persuaded to buy after a long night out at a conference in Barcelona that involved a private concert by Girls Aloud.

The broker sends the three lists to various firms that might be interested in the bonds. He promises them that if any of their bids are successful or come second, then they will be told the cover (the highest unsuccessful bid) for all the positions. This colour on where CDOs are trading is hugely valuable to investors and traders.

In fact, flushing out some real prices may well be the insurance company’s main reason for sending out the bid list in the first place. But while the seller wants this information for himself, he is not keen for others to share it. So he insists that all the covers should remain secret.

The broker, confronted with a moral dilemma, decides the only fair thing to do is to lie to both sides. He promises the seller that there will be “no colour” while whispering to all bidders that he will show them the covers in confidence.

The broker, if he has access to the right kind of software, may send some analysis on each of the CDOs on the bid list to help would-be investors decide if they like what they see. He also sets the time and date that the auction will close.

At the close of the auction, the broker tots up the bids and figures out if any met the seller’s reserves. And even then the process is not over. For those bonds that fail to trade the broker will often go back to the highest bidder and try to elicit a better price – perhaps pointing out how close the bid was to the seller’s reserve price.

While this method of selling bonds may seem comically inefficient or downright improper, there is nothing inherently wrong with buyers and sellers meeting in this way. The more illiquid an asset (think of houses) the greater the tendency for information to circulate informally.

But as growing numbers of new funds have targeted CDOs – CLOs in particular – calls are growing for the market to become more transparent. One initiative that should help is a recently launched data service – Creditflux B-wic Tracker – which allows Creditflux subscribers to browse recent bid lists and search for prices on particular bonds.

That should help shine a light on a market which is already moving in the direction of greater openness as liquidity increases. But buyers should beware: liquidity may not be here for ever. The last time a secondary CDO market flourished – in 2002 – it vanished almost as quickly as it arrived, crowded out by a resurgent new issue market.