While some CDO issuers have packed up and left the home equity loan space amid worsening credit performance, others say they plan to stay put. Perhaps the difference between the two camps depends on where, exactly, in the HEL space they've been camping out in recent months.
Those stuck in the equivalent of the Lower Ninth Ward of subprime mortgages - during the storm of borrower delinquencies and originator bankruptcies - may not be as keen on subprime as those that were perched on a higher spot. But to the subprime bulls out there, fleeing to another credit sector would be a mistake. Their reasoning: While the sector may have weakened, the storm, following years of easy credit, has yet to hit such sectors as commercial real estate and leveraged loans.
And, advocacy groups and the federal government are already in the process of securing aid to subprime borrowers. Assuming foreclosed upon subprime borrowers do not end up in Federal Emergency Management Agency trailers, is running to other asset classes the best option?
Standard & Poor's and Moody's Investors Service each released reports last week warning of worsening credit performance in the commercial real estate sector. Moody's said it will "likely" increase CMBS subordination levels to compensate for increased credit risk. "The subprime elephant in the room' has generally renewed attention on credit in other sectors," Moody's analysts wrote last week. "The parallels between underwriting developments in the subprime and CMBS markets are striking ... and indicate that acting now should help mitigate potential CMBS losses in a future downturn."
S&P pointed to CDO demand in particular as a driving force behind crumbling CMBS credit quality. "A changing CMBS landscape - characterized by increased liquidity, fierce competition among loan originators, an influx of new buyers, and a CDO-focused/short-term mindset - has significantly altered the market's supply/demand dynamics, possibly making transactions more vulnerable to negative credit events," S&P analysts wrote last week.
S&P cites a number of deteriorating underwriting standards for commercial mortgage loans, including relaxed requirements for capital expenditures, an increase of interest-only loans and loans secured by esoteric collateral.
Meanwhile, even though similar underwriting concerns surround the leveraged loan market, issuers are primarily concerned with collateral spreads. Despite all-time-low loan default rates - 0.45% by issuer and 0.23% by principal amount, according to S&P - CLO spreads are widening. New-issue CLO spreads are out anywhere from one basis point on triple-As to 40 basis points on double-Bs, since March 15, according to JPMorgan Securities. Spread widening has been more dramatic in secondary trading, as investors show increasing sensitivity to risk.
As in the case of leveraged loans, even if credit does not deteriorate substantially, commensurate spread widening is due as the HEL saga plays out, some say, making warehousing such collateral a potentially risky proposition. To them, a "flight to quality" does not mean jumping sectors, but rather, sticking with an asset class in which negative credit woes are already (somewhat) known to them - and where spread widening is already under way.
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