Lehman Brother's ABS strategists are cautious on aggregate U.S. consumer credit quality in 2002, which is likely to challenge ABS CDO managers this year, writes the firm's head of CDO research, Sunita Ganapati and Philip Ha.
The consumer credit cycle tends to lag the corporate cycle, as seen in the historical relationships seen between the unemployment rate and GDP growth. For the ABS market, the implications are that subordinates of subprime credit product are vulnerable to detioration. Standard & Poor's announced last Thursday that the ratio of downgrades to upgrades initiated during 2001 was three-to-one, the same as 2000. However, the ratio of downgrades to upgrades increased to eight-to-one during the fourth quarter.
ABS CDOs are vulnerable to deterioration in their underlying collateral, largely because these vehicles are mostly seeking the ABS assets with the highest yield, such as mezzanine CDOs, franchise loans, and esoteric assets where the manager is paid for the credit work. Credit card and auto subordinates have limited risk, but are rarely seen in ABS CDOs. While ABS CDOs frequently have high concentrations in real estate ABS, deterioration is likely to be seen in some HEL and MH subordinates, Lehman argues.
Lehman's ABS strategist is a "seller of credit risk" in the HEL sector, which typically comprises 10% or more of the collateral in ABS CDOs. In addition, ABS CDOs often have 10% buckets of triple-B CDOs, which saw many downgrades in 2001 and volatility in 2002 is expected as well.
"For the ABS CDO manager, 2002 is similar to what the corporate CDO manager experienced in 2001," says Lehman. "Skirting credit problems will be critical. The slim subordination levels below triple-B ABS CDOs (4% to 5%) will be put to the test like they were for IG CDO and synthetic CDOs in 2001," writes Lehman.
To be fair, ABS CDOs have some structural advantages over corporate CDOs that may make them more resilient, adds Ganapati. These deals often have stronger legal language than other deals, cashflow diversion triggers to rebuild par value, and these managers often are CDO investors themselves so they understand the structures quite well, she said.