An ugly cloud continued to hover over Southern California's otherwise beautiful, unseasonably warm weather last week. And no, it was not the smog. It was the ugly, frenzied turmoil that's struck the subprime lending industry faster than anyone seemed to expect.
Loan defaults and pulled liquidity lines have mounted at such a speed that market participants are anticipating this subprime "melt-down" will trump that of the late '90s - a time period that now ailing lenders such as New Century Financial Corp., have long considered a badge of honor to have lived through. Up until recently, most had expected the largest lenders to stay intact, leaving smaller, less-well-capitalized shops to consolidate or file Chapter 11. But now, as big name lenders such as New Century and Accredited Home Lenders clamor for funding, many in the industry are left scratching their heads.
Seeking a reason for why this housing boom-bust cycle seems to be crashing with more severity than that of the recent past, industry observers have, of course, pointed to the CDO sector. CDOs, eager for high yielding assets, have sucked up mezzanine subprime bonds like they were going out of style, and investors have done the same with their notes, and just as fast. But when one of the elements of the so-called CDO machine's operating cycle was largely cut back - Wall Street funding - conditions in the already ailing subprime lending market were exacerbated.
CDOs poured into the market during the first two months of this year at nearly double the pace of last year, as dealers hastened to price deals amid the declining real estate market, Morgan Stanley analysts wrote last week. The analysts noted that nearly one out of two CDOs issued to the market last month was backed by ABS.
Total CDO issuance this year reached nearly $91 billion as of March 9, compared with roughly $56 billion at this time last year, according to JPMorgan Securities. Mezzanine structured finance CDOs constituted 19% of overall issuance, bringing $17 billion, compared with 15% of issuance at $8.6 billion at this time last year. Meanwhile, high grade CDOs were 28% of issuance, at $25 billion, compared with 20% of issuance a year earlier, at $11.2 billion.
The buying element of CDOs, some argued, has sustained the U.S. housing boom for a longer period of time than it would have normally lasted, and stoked funding to borrowers who, under normal conditions, would still be renting. And while CDOs would be ready and willing to help out by buying more subprime securities, subsequently allowing those borrowers to refinance, U.S. regulators and institutional liquidity providers to subprime lenders appear to be pulling the plug, at least for now.
The Mortgage Banker's Association last week predicted a 30% decline in subprime collateral this year. So where will CDOs turn for collateral? As of year end, some of the largest CDO asset managers were gearing up for shifts toward commercial real estate and trust preferred securities collateral - not to mention reaching a foot across the Atlantic into the burgeoning Asian CDO sector.
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