Last week's introduction of a tradable index for synthetic home equity asset-backed securities is without question expected to provide more liquidity and a more diverse set of options for market participants interested in either buying or selling protection on home equity bonds. But one question does remain: how cash and synthetic spreads - volatile in the sector due to recently increased liquidity and often mismatched supply and demand fundamentals - will react.
Markit Group Limited on Thursday, along with 16 investment banks, launched the synthetic ABS index of U.S. home equity ABS, called the ABX.HE. The ABX.HE is comprised of five indices referencing baskets of single-name ABCDS on subprime RMBS reference obligations ranging from triple-A to triple-B minus.
As of press time, the indices had opened to relatively sporadic activity, with many investors said to be waiting for the markets to settle down before jumping in. Triple-B and triple-B minus indices had begun to trade lower by as much as one basis point, while the triple-As rallied by nearly four basis points.
Many speculated that index spreads might end up wider than single-name spreads. "My concern would probably be if there were more buyers of protection on the index, and more sellers on the single name, that there would be a dislocation - a supply and demand issue," said Joseph Cafiero, president of asset management firm CREMAC. Cafiero said his firm, which owns credit risk management company Risk Management Group, is looking to sell protection on synthetic home equity residuals. But he, like others, is waiting on the sideline for an indication of the best strategy going forward.
Some, such as Credit Suisse, speculated the divergence would occur because sellers - namely CDOs - might favor the single-name market, while buyers are likely to flock to the indices. Differences in contracts between single names and the indices, particularly the lack of an actual physical settlement in the indices and the lack of a coupon step-up, stop the ability of a basket of single-name swaps to mimic the index. That, according to Barclays Capital analyst Joseph Astorina, will always mean a divergence in spreads.
Astorina added that the chances of headline risk playing with index spreads, at least initially, could be muted because all of the index deals are currently new issue. "For something to happen - I'm not going to say it is impossible - but if something negative happens to one of the issuers, if it is an older deal, it might not have much of an impact," Astorina said.
Players anticipate new opportunities arising from ABX.HE. "We expect that in the near future, similar to the corporate CDS space, the index will become the benchmark for new product innovation and lead the product evolution cycle of the synthetic ABS market," Bear Stearns Senior Managing Director Gyan Sinha wrote last week.
The index will allow for a wider range of trades using the home equity swaps. For one, investors will have a chance to gain a broader exposure to the market, take macro views on the housing sector and execute pairs trading across rating classes and, eventually, across vintages, according to Lehman Brothers. Investors will also be able to directly trade on relative value between the sector and other markets such as corporates. And, finally, investors will gain a much more transparent benchmark for pricing CDS - which will help to satisfy back offices and greatly increase efficiency and liquidity.
Because the index will only include the largest home equity ABS issuers who are able to pour more money into servicing, fraud surveillance and underwriting, the chance of a rash of defaults and downgrades is thought to be less likely. And, investors interested in only taking exposure on new-issue spreads can continue to roll into new indices, a move that will significantly reduce risk since significant collateral losses typically don't take place in the first six months, according to JPMorgan Securities. Conversely, investors wishing to gain exposure on later vintages can do that once the indices age.
Volume is expected by many to shadow the massive growth seen following the implementation of the synthetic index for corporate names. The outstanding notional amount of the corporate CDS market is estimated at some $8 trillion. "With at least 15 dealers pledging liquidity commitments to the index, including RBS Greenwich Capital, ABX is the next generation of synthetic consumer and mortgage credit risk trading," said Peter DiMartino, managing director at RBS Greenwich.
Continued cash volatility?
A flood of investors poured into the single-name sector following the International Swaps and Derivatives Association's release of standard documentation for pay-as-you-go settlement procedures on asset-backed CDS in June 2005. JPMorgan estimates some $20 billion to $40 billion notional of contracts have been executed in the space. And, JPMorgan points out, "as the market developed, ABCDS has introduced tremendous volatility into the subordinate home equity space."
While subordinate cash home equity spreads tightened from the fourth quarter of 2005, some, including JPMorgan, are anticipating continued volatility in the sector.
Floating-rate cash and synthetic triple-B home equities tightened by 35 and 20 basis points last week, respectively, and by 60 and 50 basis points so far this year, according to Credit Suisse. At the height of protection buying madness, triple-B minus home equity CDS spreads were as much as 75 basis points wider than cash bonds - as of last week, synthetic spreads sat inside cash spreads.
"The growth of the synthetic market will likely continue to create higher volatility in cash pricings, but increase overall pricing efficiency in the long run, given the past volatility of the ABCDS market, as well as the rising rate environment and housing slowdown that have yet to fully play out." JPMorgan analysts said, adding that even though CDOs have seen improved arbitrage conditions, fueling demand for subordinate home equity ABS and protection selling, spreads are likely to follow historic patterns.
But not everyone agrees. "Not only do we expect synthetic spreads to avoid a similar spike to the one seen a couple of months ago, we also believe that spread technicals should likewise prevent any near term spread widening in the primary market," said Credit Suisse analysts. They are not anticipating synthetic spreads to gap back out because of "new market dynamics" such as Regulation AB and a robust CDO pipeline, which are creating less cash home equity ABS supply.
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