CDOs Lose Buzz as Market Turns Turbulent

Just a few months ago, the market buzzed with news on the latest municipal CDOs — who was marketing them, who was planning them, and who might be interested in buying into the new-fangled tax-exempt products. But recent market turbulence has quelled much of that talk.To date, only one such deal, Merrill Lynch & Co.’s Non-Profit Preferred Funding Trust I, has closed. Meanwhile, UBS Securities LLC pushed back the closing on its Republic Funding Trust I — originally due to close in July — and sources have said widening credit spreads and rising yields have forced interested firms to change the underlying bonds for their planned trusts and put their projects on the back burner.“It seems like people are taking a wait-and-see attitude right now,” said Jim Leahy, vice president and senior credit officer at Moody’s Investors Service. “They want to see less volatility, and they want to see a better market to issue in.”CDOs, or collateralized debt obligations, have been common in other fixed-income markets for years. During 2007 alone, 424 CDOs worth a combined $231.7 billion have been sold in U.S. markets, according to Thomson Financial data yesterday.Like the CDOs found in other fixed-income markets, the tax-exempt versions take an underlying pool of credits and repackage them into stratified tranches, allowing investors to buy trust certificates rated as high as triple-A and as low as an unrated equity-styled level. The muni-based deals are referred to as structured tax-exempt pass-throughs, or STEPs, and are structured a bit differently to allow proceeds from the trusts to remain tax-exempt.For a while, the concept of creating new STEPs had grabbed the interest of a host of muni broker-dealer firms. More than half a dozen firms were rumored to be developing their own plans.Brad Winges, head of fixed-income sales and trading at Piper Jaffray & Co., recounted a call he got from a CDO manager he’d never heard of who had begun eagerly amassing muni bonds with a warehouse line of credit from a Wall Street firm.“A year ago, he’d never bought a muni in his life,” Winges said. “Now he was trying to buy up to $500 million and do the CDO takeout. That was a month ago, and I haven’t heard from him in a while.”Firms now seem more guarded about whether they are actively planning to structure bonds into future STEP transactions.Winges said he frequently asks buyers he speaks with about their plans for the bonds — especially those with higher yields — that they buy in Piper Jaffray’s deals.“Is it going into a [tender-option bond program]? Is it going into a bank account just because they want the tax-exempt income, where they’re not necessarily doing the full hedged carry trade? Or is it ultimately for six months down the road and a takeout for a structured product?” he said he asks them. Winges added that he was interested to hear what the sources of demand for the bonds were because his issuer clients want to structure their deals accordingly.“Ultimately, that’s what the issuer wants — they want the best economics,” he said. “So, if carving it up six ways from Sunday gets them there, then maybe they’ll work with you on that.”Winges said Piper Jaffray is also still considering two separate options for potential CDO-styled muni deals.For firms mulling whether to form a STEP, it makes sense to warehouse many, if not all, of the bonds before marketing the trust to investors.Potential STEP investors tend to be the same accounts that would look to buy the deals’ underlying bonds in the cash market. Unlike CDO investors from taxable markets, STEP investors tend to focus on the credit of the underlying bonds, not just the ratings assigned to the tranches by major rating agencies. As such, they prefer to see that as many of the underlying bonds as possible are in the trust before the deal closes.Merrill’s Non-Profit deal, designed to be about $400 million in par volume with a 250-day ramp-up ­period, had about 50% of the underlying bonds purchased at closing, according to rating agency reports. The Republic deal, which still has not closed, was to be about the same size with a 180-day ramp up period and 70% of the bonds warehoused by closing.Merrill declined to comment for this story.UBS spokesman Doug Morris said his firm could not comment on why it pushed back the closing on its Republic deal. He said UBS is still in a mandatory quiet period ahead of closing that deal.Another reason to collect bonds before deciding to pull them out into a separate CDO-like structure is the risk that yields on those bonds will rise.On May 3, when Derivative Fitch published its presale report on the Republic trust, the average yield on 30-year maturities of low-investment-grade municipal bonds was 4.45%, according to Municipal Market Data. The average yields on 30-year maturities of these bonds now sits at 5.23%. The change shows how rapidly yields have been rising on lower-rated bonds.Up to 80% of the underlying bonds in UBS’ Republic deal can be below investment grade, according to Derivative Fitch. This means many of the bonds originally pooled for the deal have likely devalued significantly in recent months.Legal details regarding STEPs’ tax-exempt status require that the underlying bonds cannot be swapped out once they are put into the trust. This means that deals that close with lower-yielding bonds cannot replace them if market yields rise.But Leahy from Moody’s said the ongoing credit and liquidity crunch has not changed the overall credit profiles of the STEP deals. He added that much of the slowdown is due more to psychology than substance and that he expects the interest in STEPs to pick back up as market conditions improve.