Once considered a foray into the capital markets frontier, European CDOs of ABS have quickly become fortresses of safety, promising to add some of the needed cushioning investors have sought. CDOs of ABS have grown to represent at least 20% of the European market, and sources predict that the market could grow to represent 50% of CDO issuance volume by the end of the year.

"The market is very active this year," said Paul Mazataud at Moody's Investor Services. "And though it's still too early to quote any exact figures, we anticipate to see volumes reach higher levels than last year."

"The type of transactions, however, are quite different," he added. "The market will be largely dominated by two categories: mostly synthetic CDOs of ABS and leveraged loan CLOs."

The impetus behind this growth can largely be attributed to investor demand for safety, as these two categories have largely escaped the defaults and negative ratings actions that overtook last year's more popular corporate bond CDO structures. Both CDOs of ABS and leveraged loan CLOs have proven to be extremely stable in terms of ratings. The leveraged loan arena has seen no downgrade activity, according to Moody's, and downgrades among CDOs of ABS have been minimal and limited mainly to structures with corporate exposure.

CDOs of ABS structures are slated to represent the most substantial portion of the market this year. According to Dresdner Kleinwort Wasserstein, the transactions emerging from this sector - both on the cash and synthetic sides - are typically divided into two categories: highly leveraged deals backed by a small number of triple-A rated tranches, and less-leveraged deals backed by a larger number of subordinated obligations.

Mazataud at Moody's added that a number of these deals are executed through the private market and will generally incorporate customized CDOs as the underlying ABS. "Take, for example, a synthetic CDO exposed to ABS and other structured finance instruments," he said. "If you look at the underlying CDO portion, you may see some real CDOs issued some time ago, but most of what we're seeing are CDOs designed specifically for that CDO of ABS."

These customized CDOs are pure mezzanine synthetic transactions that take the form of credit default swaps. Reaching a sufficient level of diversification can sometimes be a problem when putting a portfolio in place. It's difficult to generate ABS quickly, but it's extremely easy to create a portfolio of diversified exposure on the CDO side - a synthetic static transaction offering stable diversification levels can be created in 24 hours. JPMorgan Securities and BNP Paribas have been very active, executing a number of deals in the private and public markets. In addition, Bear Stearns completed Faxtor's first true-sale CDO of ABS transaction in April.

"Faxtor is on the extreme end of CDOs of ABS because it had a very defensive portfolio," said Mark Moffat at Bear Stearns. "[It was] primarily consumer-based and real estate with a bit of SME exposure - investors like that. We sold a number of tickets to investors who had never done a CDO before, and we saw investors at the senior level who had not bought CDOs in a number of years." This structure reflects what investors want to see - a degree of stability not found in investment-grade or U.S. high yield. Leveraged loan and ABS deals launched this year have managed to achieve competitive pricing as well, market sources said.

Cash-leveraged loan transactions have maintained their appeal in a market notoriously wary of high-yield paper, but these transactions are typically smaller and can often take longer to arrange and rate. Nonetheless, there has been a growing number of managed transactions since the market caught on last year, and the ability to execute these leveraged loan deals has been evidenced by a growing investor base. Dresdner reported that a trend common among some recent deals is a longer ramp-up period and the use of a dynamic funding structure.

A look at the remaining structures surging through the pipeline still shows a few deals backed by corporates, though significantly less than those in 2002 and originating predominately from the synthetic side. "We expect a reduction in downgrade activity," said Mazataud. "Maybe things are improving, but we are still not in a stable ratings environment."

According to Moody's, corporate- and speculative-grade default rates are at two-year lows. Although downgrades are falling in the U.S., they reached record levels in Europe in the first quarter of 2003. "While stabilization has started to set in, downgrades are still likely to outnumber upgrades going forward on the back of weak corporate earnings and issues such as pension shortfall and litigation risks," reported Dresdner.


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