The slowdown in the collateralized debt obligation (CDO) and collateralized loan obligation (CLO) markets is leading some Wall Street firms to refocus on their core competencies by shifting "non-core" mid-level and back-office functions to third-party specialists. This shift stems from a growing belief that the current downturn will last longer than first expected and that outsourcing may offer a way to ride out current market turbulence while maintaining vital operations.
Since many of the back-office core functions of CDO underwriters and portfolio managers are similar to those of the CDO administrator (servicing of leveraged loans or credit default swaps, for example), reallocating some of these functions to a third-party may provide significant overhead and administrative cost savings, especially where the service provider has the core competencies and economies of scale necessary to deliver an independent service without conflict.
Before the credit crisis unfolded last summer, the CDO market had grown to become a benchmark fixed-income product in the global debt capital markets with more than $1.5 trillion in outstanding debt. Large global trustees, such as The Bank of New York Mellon, have been integral to this growth, providing administrative, trustee, and agency services to CDOs since they first came to market nearly 20 years ago. According to Moody’s Ratings Interactive Database, The Bank of New York Mellon has been appointed as service provider on nearly half of all CDOs rated by Moody’s since 1993.
Bank Outsourcing
In recent months, market participants have begun to rationalize their core competencies and have explored the value of outsourcing parts of their operations. With the slowdown in securitization, banks that typically originate loans for their own balance sheet, or for syndication or securitization, are evaluating whether to outsource back-office loan administration and reconciliation functions. Some banks are also considering outsourcing certain middle-office support functions.
As the largest CDO trustee in the world—serving more than 500 investment banks and asset managers in a variety of administrative and agency roles--we have received a steady increase in these outsourcing inquiries over the past 12 to 18 months. With administration specialists spanning the globe and a global loan database that has on record more than $250 billion in syndicated bank loans comprising more than 10,000 loan facilities worldwide, this experience and infrastructure has positioned the Bank as an ideal partner in the outsourcing space.
Investment banks have further inquired about outsourcing total return swaps (TRS) processing functions. Such middle-office services encompass general loan administration functions and more specifically, legal execution and settlement of loan assignment agreements. These functions call on different skills and competencies, some of which we have leveraged from transaction management capabilities in documentation review and negotiation.
Servicing TRS transactions also requires dedicated and responsive teams that have a comprehensive understanding of the unique structures, and can provide customized reporting. In servicing these requirements, our TRS team includes a specialized trade settlements group that can expedite transactions and handle both onshore and offshore deals.
Other requests have included outsourcing of credit derivatives administration (notably credit default swaps, or CDS). Credit derivatives operations form the backbone of many trading and prop desks of investment banks that structure synthetic CDOs, either for distribution or for managing their own balance sheet risk. Many smaller institutions generally do not have the robust systems or industrial scale necessary to manage these operations efficiently.
Clients have further requested information about the provision of independent verification services, such as data reconciliation between trustees and collateral managers.
Asset Manager Outsourcing
CDO, CLO and hedge fund managers are exploring the benefits of outsourcing as well. Back-office collateral administration functions usually represent the first area to be outsourced on the buy-side, but other tasks such as portfolio analysis, compliance testing, and verification are being considered.
Many asset managers are assessing the potential benefits of outsourcing in-house administrative processing related to the servicing of trading and investment portfolios. Their goals are to reduce risk and costs, improve operational efficiency, and provide better client services by focusing on core strengths.
Credit market turmoil has reduced the number of structured finance transactions in the pipeline, forcing many firms to cut expenses. With fewer deals being done, investment banks, CDO managers, hedge funds, private equity funds, and other investors will continue to focus on their core competencies.
These firms are turning to well-established and trusted service providers such as The Bank of New York Mellon, whose core capabilities are well suited to providing back-office and middle-office support functions. As in the past, shifts in the business cycle ultimately reveal which business partners have the ability to adapt and change in keeping with the needs of their clients and market conditions.