After a tumultuous summer in mortgages triggered a whirlwind of CDO downgrades, this past year will not be seen in a positive light for U.S. ABS CDOs.
Despite growing issuance in the first half of 2007, CDO defaults in 2H07 as well as continued mortgage credit losses have dug the product's grave for 2008, market players said.
Issuance in Structured Finance CDOs dropped to $22.2 billion in 54 CDOs for 2H07, from $141 billion in 215 deals for 1H07, according to Dealogic data.
Perhaps the most defining moment in 2007 for ABS CDOs was the massive U.S. RMBS downgrades on July 12. This bloodbath of negative rating activity that hit the collateral underlying the majority of these CDOs signaled that such investments might not yield their expected value.
Currently, 15.66% of the total notional amount of vintage 2007 CDOs has been downgraded by Moody's Investors Service and Standard & Poor's in the period from July 1, 2007, to Jan. 2, 2008, according a Wachovia Securities report. The total balance of downgraded tranches is $32.5 billion for the 2007 vintage. For vintages 2006 and 2005, the total notional amount downgraded is 9.5% and 0.82%, respectively, and the total balance of tranches downgraded is $31.9 billion for 2006 and $1.4 billion for 2005, Wachovia said.
Price dislocation in CDOs fueled by these downgrades has not only halted new issuance but has made the value of existing CDO securities almost impossible to assess.
Declining valuations have triggered events of default (EOD) in the sector. Over the past two months, more than 50 ABS CDOs have experienced an EOD resulting from the credit deterioration in the nonprime RMBS market, according to Moody's. Furthermore, Merrill Lynch analysts said in a recent report that they expect another wave of EODs to be announced in January, as recent ABS downgrades have caused further haircuts on the senior OC tests enforcing the EOD.
Downgrades have also pushed out investors from the CDO space altogether, which has happened even when the collateral was not directly related to RMBS. For example, in early fall CLOs took a nosedive in issuance and saw the sector's liability spreads widen out as a result of subprime headline noise.
Although liability spreads have come back in a bit after the initial market hysteria and new issuance appears to be trickling in, an expected increase in corporate defaults resulting from declining economic conditions could create future complications for these vehicles, market participants speculate.
However, the downgrades have also weeded out the stronger CDO managers from the weaker ones, in a market where managers had been previously been spreading like wildfire. BlackRock and Western Asset Management Co. stood out with two of the more stable U.S. SF CDO performance scores of 2,' according to Derivative Fitch. Of BlackRock's 12 outstanding SF CDOs, none have experienced tranche downgrades below B-,' a rarity within the SF CDOs reviewed by Fitch, the rating agency said. Declaration Management & Research and E*TRADE Global Asset Management were among the weaker managers, with stability scores of 3-.'
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