U.S. CDO issuance has continued its rapid growth thus far in 2007, despite contraction in the subprime market, which has traditionally been a popular source of collateral. But the investment vehicle may be running out of fuel as market players credit its solid year-to-date performance as spillover from 2006.
Indeed, CDO issuance so far this year is at $142.1 billion, up from $103.6 billion for the same period in 2006, according to data provider Dealogic. While the number of transactions in the first quarter of 2007 was lower than in the final quarter of 2006, the number and volume of transactions were up 100% over the first quarter of 2006, and 2006 was up more than 60% over 2005, according to a recent report from Moody's Investors Service.
But a lot of this year's issuance, especially of first-quarter 2007 paper, is a continuation of deals ramped last year, said Shirley Zheng, senior vice president in the credit mortgage group at Trust Company of the West. The 2006 collateral continues to be a significant part of 2007 deals that people are buying in the primary market. "I do not think recently issued CDOs are using that much of 2007 because of the lack of seasoning and lack of performance," Zheng said.
Some of the first quarter's activity was also the result of arrangers working to clear inventory and reduce their balance-sheet exposure to the subprime class of resecuritization assets, said Richard Michalek, vice president and senior credit officer at Moody's. "I think that some banks may have partially ramped up some cash resecuritization transactions throughout the fourth quarter, and there was a concern that in part because of the way the ABX was moving, they needed to quickly move to complete these ramp-ups," he said. "There was an intensity towards issuance in the first quarter that reflected some of the impatience relative to other years."
While Moody's expected CDO issuance to have another record-breaking year, it does not expect the remainder of the year to keep pace with the first quarter. In the past, issuance in any subsequent quarter could be predicted as a multiple of the first quarter's performance, the rating agency said. "While we are expecting cautiously another record-breaking year in 2007, we will not be surprised to see the overall activity redistributed somewhat towards the first half of the year," Michalek said.
Issuance in the first half of the year saw a particular emphasis on CDOs of CDOs, mezzanine structure finance resecs (primarily as hybrid CDOs), and CDOs containing large baskets of CDOs, Moody's said.
The market is also seeing more high-grade paper than mezzanine deals, TCW's Zheng said. And "looking at high-grade ABS CDOs, we are seeing more prime and Alt-A assets being added to these transactions."
The aversion to subprime exposure contributed to the trend in resecs toward high-grade structured finance, which, in turn, led banks that retain super senior exposure in the capital structure to find additional transactions in order to reduce their mark-to-market exposure from any retained super senior tranches, according to the Moody's report. "Structures were responding to investors moving toward the higher end of the capital structure on the asset side by structuring more high-grade ABS resecs. But that created the need to unload any retained risk - including any super senior tranches - through additional transactions. Once concentration is focused in one area, there will inevitably be some activity to try to spread that risk again," Michalek said.
Loans Remain A Factor
CLO issuance also remained incredibly robust as subprime slowed, with increased loan volume providing what seems like endless collateral. Indeed, institutional loan volume so far in 2007 is at $235 billion, according to Standard & Poor's Leveraged Commentary and Data, already at three-quarters of 2006's total record volume, according to a recent report from Deutsche Bank.
There is also a greater willingness to embrace complexity in new structures. One example is the increase in foreign currency exposures in CLOs, Michalek said. "There is an appetite for CLO exposure, so boundaries are being tested and returns are being pursued and structures are finding that there are plenty of buyers for it. We are seeing the inclusion of complicated parameter matrices that are allowing dynamic capital structure management," he said, noting that these structures would have once been more of an outlier based on the complicated structure. "Now it seems demand is sufficient for even more complicated structures, so it is hard to say what is relatively too complicated."
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