As expected, CDO managers feasted on the recent bout of asset-backed credit default swap spread widening - producing a two-fold effect of reeling spreads back in and pushing the burgeoning CDO pipeline out.
Mezzanine structured finance CDOs sourcing synthetic assets have made up the bulk of new-issue activity since ABCDS spreads widened, according to JPMorgan Securities. Triple-B minus ABCDS rose roughly 50 basis points from late August to mid-September, at the same time the total notional amount of mezzanine structured finance CDOs in the pipeline grew from about $7 billion to $22 billion, according to JPMorgan.
Bids wanted in competition outnumbered offers wanted by roughly five-to-two at the end of October, as protection selling CDOs outnumbered protection buying hedge funds, according to Credit Suisse. RBS Greenwich Capital reported more than 425 line items for bid and offer last week, with several bid lists across the capital structure carrying a notional value of more than $3 billion. CDO activity was so heavy, traders said last week, that demand has compressed single-name CDS spreads inside of cash.
Signs of weakening
But while the spread reduction is a boon for the home equity sector, as it indicates continued demand for the securities, market participants point out that there are signs of weakening that may not be easily glossed over by the CDO and hedge fund game of spread tug-of-war. For example, while home equity loan CDS protection sellers have been asking for more money to sell protection on deals backed by certain issuers for some time, the divergence is beginning to leak into the new-issue cash sector for the first time in a long time.
"Negative sentiment is apparent in the sharp tiering among issuer names now prevalent in not only ABCDS, but also new issues," JPMorgan analysts wrote last week. Triple-B tranche pricing had broadened to a range of 130 to 190 basis points, while triple-B minus tranches were in a range of 180 basis points to 275 basis points over Libor.
Some market players last week said they expected short interest to creep back into the market, as indicators are looking more negative than positive for the subprime sector. The number of 60-day-plus delinquencies within both of the ABX series inched upward in October, displaying a faster rate of deterioration than earlier vintages. About 7.3% of loans referenced by the 06-1 series were more than 60 days delinquent, ranging by pool from 3% to 11%, while the 06-2 series averaged 5.2%, with a range from 0.8% to 9% at the end of October.
Hedge fund demand to short the home equity sector was blamed for the recent bout of spread widening throughout September and early October. The amount of cash flowing through on dealer for ABX.HE trades alone has doubled 2.5 times since April, according to one trader. Across the board, triple-B and triple-B minus index tranches constitute the bulk of activity, as macro hedge funds and others look to bet against the riskiest portion of home equity deals. In fact, a day's worth of volume within the triple-B minus tranche of the ABX indices could well outpace the notional amount of the underlying bonds.
The sheer amount of cash horning in to short the index has made it costlier to do so. Spreads for both index products, as well as single-name derivatives and cash have begun to widen. But even amid the widening frenzy, the market could turn quickly if this group of fickle investors rushes to unwind trades amid a slightly more optimistic housing market outlook. In fact, Bear Stearns analyst and Senior Managing Director Gyan Sinha had warned investors not to "bet the farm" on any particular set of outcomes for the housing market.
As of last week, investors were guided to hedge short index bets with long positions. JPMorgan advised clients to hold onto short ABS 06-2 triple-B and offset the position with long cash double-B plus securities, which at the time had a differential of 410 basis points.
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