CDO spreads are tight and it appears major U.S. insurance companies have sold all the distressed collateral they care to let go of at this point, according to the industry's secondary traders last week. Yet, what sounds like a dour situation is anything but for a market that feeds on innovation. Traders believe more sophisticated analysis will lead to a more liquid secondary market for various types of CDO collateral, with some traders nodding towards ABS CDOs.
"Our struggle is to find the sellers. Selling by U.S. insurers - I think that's over," said Keith Grimaldi, a director at UBS, speaking at last week's CDO Conference hosted by The Bond Market Association.
Traders spoke about the mezzanine level, where action has shifted as any senior pieces were snatched away months ago. "The rally in the credit markets lifted all parts of the capital structure; some of the mezzanine levels rallied but these are still second- and third- priority bonds, so cash isn't coming anytime soon" said Michael Klurinets, vice president at Credit Suisse First Boston. "That's a potential downside so be aware. To us these are risky assets."
Given structural changes the rating agencies demand, there is a huge distinction between ABS CDOs structured before 2002 and those since, primarily due to changing beliefs about diversity and diversity scores. Session Moderator Adam Siegel, managing director, Bear Stearns, inquired as to if a fellow trader thought there was a view that the newer deals were going to perform better and if a traditional secondary market would develop for older, pre-2002, ABS CDOs.
"The experience in the high yield market will be instructive here," added Ross Heller, vice president at JPMorgan Securities. Where distressed ABS paper trades right now could be written off; on the other hand those with experience could come in and slowly but surely build up a secondary market as was the case in the high yield market, Heller said.
A part of the ABS CDO market has huge potential, with trades driven by distressed deals, agreed Erik Siegel, vice president, Morgan Stanley. However, "deals closing today, we probably won't see them come back to the market as there'll be other vehicles and there will be little reason to sell them," Siegel added.
Currently, there's difficulty trading ABS - or structured finance - CDO paper primarily because pricing is not transparent, making a less liquid market, traders felt.
However, downgrades help by creating more collateral that investors need to unload. The secondary market panel of traders collectively believes that in the next six months or so, rating agencies will begin to downgrade 2000 and 2001 ABS CDO vintages.
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