Analytical Challenges in Secondary CDO Market Trading

The secondary CDO market has grown rapidly. Annual par traded totaled approximately $2 billion in 2002, then soared to $14 billion in 2003 (about half of that from Abbey National sales), to $25 billion in 2004, and $30 billion in 2005. More importantly, the secondary market has become an important part of CDO investor thinking, providing a second chance to acquire CDOs and rewarding rigorous analysis.

One reason for the secondary CDO market's growth is the significant increase in resources available for analyzing outstanding CDOs, chiefly the availability of CDO-specific cash flow models. However, potential buyers of secondary CDOs still face challenges when considering a purchase. A very liquid secondary CDO market, trading with the ease of corporate bonds, will probably never be achieved. Cash flow CDOs, with idiosyncratic portfolios, management, and structures, will always be complex and take time to analyze.

In this chapter we first review secondary market developments and pitfalls. Next, we provide a step-by-step guide to evaluating a secondary CDO. We pay particular attention to two popular analytical methods: net asset value (NAV) analysis and cash flow modeling. These two techniques have improved investors' understanding of CDOs and therefore secondary market liquidity. But they must be implemented with care.

We demonstrate that NAV can produce results far from the actual trading level of secondary CDOs. The ...

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