As if the Bear Stearns liquidation were not enough to ruffle the ABS CDO market, industry participants expect similar meltdowns to occur within the next few weeks. And as difficulties increase in placing portions of ABS CDO issues across the credit spectrum, further market drama will only weaken the demand.
A recent research report from JPMorgan Securities noted that given the liquidation of some high-grade structured finance CDO positions at wider spreads, dealer warehouse appetite has dramatically shrunk. And the recent warehousing liquidations would further slow, if not halt entirely, the already stagnant new issue market.
ABS CDOs across the board are facing difficulty selling the debt at every risk level, according to market sources. More specifically, many of the deals that were supposed to close in January or February have not closed yet, a market participant said. While some of the assets have been sold, other assets are waiting to be liquidated. "You can get away with holding certain things in the trading book for six or seven months, but eventually you have to face the music," the participant said, estimating that after the six-to-eight-month warehousing period, September or August could be when the market will get to that point.
While issues in the ABS CDO sector began well before the Bear Stearns debacle, the funds are the first to fall in what the market expects to be a chain reaction. Bear had roughly $6 billion to $8 billion in CDOs, and the subprime market is probably $1 trillion dollars, the market participant said. At the same time, double-A and triple-A ABS CDOs amount to approximately $40 billion and $50 billion, respectively the participant estimated, leaving a lot of potential for another Bear Stearns-like situation. "Within two to three weeks, we could see another," a source said.
ABS CDO hunger is also being suppressed by rating agency issues. With the continual downgrades and changes in methodology, the market does not really believe the ratings on either the subprime bonds or the CDOs backed by these bonds, sources said.
Indeed, 197 subprime bonds of 2006 vintage have been downgraded this year by Moody's Investors Service, including 10 triple-A bonds with no upgrades, according to a recent report by Citigroup Global Markets. Standard & Poor's downgraded 134 subprime bonds from the 2006 vintage with only one upgrade, the report said.
Bill Gross, managing director at Pimco, supported the idea in his July 2007 investment outlook, scolding Moody's and S&P for being mislead into thinking the RMBS and CDOs they rated had more value than they were actually worth, in particular the triple-A tranches on these deals. "What was chaste and AAA' years ago may no longer be the case today," he said.
But with low interest rates, rising home prices and ample liquidity, rating agencies have had very limited trend data and have traditionally been slow to revise their credit opinions, according to a report from Pershing Square Capital Management last month. At the same time, increased CDO issuance has brought these agencies additional fees. Structured finance accounts for 40% of revenues and four times that of traditional debt ratings, Pershing said.
Slow Seconds
Trading in the ABS CDO secondary market has also reacted to the current lack of interest in the primary market. "Everybody is shying away because there are no buyers, so no one wants to put a bid out there," a market source said. The CDO machine has traditionally been self-serving, with CDOs buying CDOs and CDOs buying ABS. With the warehouse lines very restrictive right now, a portion of the massive demand that had been driving the market has disappeared.
And with the potential for future subprime blowouts, the market has been concerned that the bid list process will send shock waves through the system if the bids for these assets come in lower than the perceived market value for these CDOs. Not only would this force managers to re-mark their entire portfolios to where the market believes they are worth; it could also shake investors' confidence. As a result, there is speculation that people are going to move funds around more quietly in order to hedge that risk - either one at a time or a few at a time - to one dealer through a friendly relationship as opposed to sending it out to 10 dealers to compete on the assets through bid lists, a source said.
Both the new issue and secondary markets are suffering a huge dislocation between where dealers offer cash bonds and where sellers of protection can execute and go long on exposures synthetically. For instance, on double-A notes, as much as 200 basis points can separate offerings in the cash and synthetic markets, the source said. "Cash markets have to come back to reality."
Back in Style
Yet while ABS CDOs may be out of fashion at the moment, all trends do come back in vogue, which is what will happen for these CDOs, several market participants say. CDOs are simplified in order to make the analysis mechanistic, a market source said, and, in the process, they give up useful real-world information, an inherent weakness that players in the market have learned how to exploit better and better. Although more stress testing and scenario analysis are required, the industry, as it is, is resilient, and "having a few deals get killed is not the same as killing the whole business," the source said.
Indeed, the CDO business has had a string of injuries that have been suppressed by the market. Corporate CDOs laden with telecom debt blew up when the bubble burst less than 10 years ago, yet the market continues to do synthetic CDOs on all sorts of corporate names as well as cash CLOs on smaller credits. At the same time, CDOs backed by manufactured housing and aircraft deals took a hit. But instead of killing the CDO industry, the troubles migrated to home equity. That subsequently lowered pricing, which threw off the value of the debt compared with the risk.
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