Credit quality is good, but residential mortgage innovations complicate picture
After a few years of bruised egos and downgraded corporate bonds, institutional investors opened up their wallets to collateralized debt obligations in monstrous numbers last year. The reason? More of these CDOs are backed by real estate, which seems to be everyone's favorite asset class.
While most of the growth last year was in better quality credits, the increasingly complicated residential market, with all its bells and whistles, adds unknown complexities. How well these securities perform, especially if interest rates turn up significantly, is still a big question.
But there seems little concern about such issues at present. Last year, issuance of ABS CDOs, the type of CDO instruments that contain a mix of bonds from real estate sectors, skyrocketed to $59 billion from $30 billion in 2002, according to Fitch Ratings. Last year, 80 cash flow CDOs of ABS were issued in the U.S., compared with 48 in 2003, according to Standard & Poor's.
"To buy ABS CDOs, an investor needs to have a view - a comfort level - on U.S. housing," says Peter DiMartino, a managing director at RBS Greenwich Capital. "They are interested in CDOs because of what they perceive to be reasonable risk/reward and relative value advantages."
One thing is certain. These days, institutional investors are facing a different ABS CDO market from what it was when the market was created in 1999, when ABS CDOs were more diversified.
"They reached into franchise bonds, manufactured housing, pooled aircraft-asset classes they didn't have primary expertise in," says Steven Finnk, senior research analyst at United Capital Markets. "Investors basically spread themselves thin across multiple sectors." When those CDOs collapsed under the pressure of blowups from a few key sectors, the CDO market had to change.
Now, Finnk explains, the market is "much more focused on core products." And the key product for ABS CDOs is residential mortgage-backed securities. "Investors are trying to stay away from some of the sectors that have proven to be more dicey due to poor performance," said Finnk.
In addition, the market's biggest growth last year was in high-grade issues, says Hedi Katz, a Fitch managing director. "The [ABS CDO] deals of the past tended to have primarily triple-B assets. [Recently] issued deals contain a lot more triple-A and double-A collateral and tended to be much larger in size," says Katz. Moreover, "most CDOs issued last year...were able to tap into the short-term market for funding of senior notes, which drives down the cost of issuance," she points out.
The downside of innovation
Innovation in the market still raises a lot of questions. While I/O loans look great on paper and have increasingly provided collateral for ABS CDOs, these securities have not been tested in the market before. What will happen as interest rates ascend and monthly mortgage payments really begin to rise, is a big unknown. Rising interest rates could also hammer CDOs packed with ARMs.
Another complication is the changed nature of home equity lines of credit, which are also included in the ABS CDO pools. Traditionally, these lines were offered after a home was purchased and were used largely for home improvement projects, but have since taken on a life of their own. These days, so-called "add on" home equity loans are paired with initial mortgages, allowing the home owner to come up with the 20% down payment necessary to sidestep mortgage insurance requirements. It is unclear how these add-on home equity lines, already tapped out at the initial purchase of the home, will perform in sync with a homeowner's mortgage.
"If these products are originated and credit enhanced properly, investors should be indifferent. However, just the nature of the loan types pose risk factors that need to be considered, as well as the notion that the rating agency has enhanced for those risk characteristics properly," says RBS Greenwich's DiMartino.
"Right now, we're going into a rising rate environment, and a prepay environment that is beginning to slow. The dynamics where prepays have made these deals so strong in terms of residential collateral probably won't continue going forward," says UCM's Finnk. Finnk, who spends a lot of time in the secondary CDO market, says he has not yet seen enough ABS CDO downgrades to affect the secondary market. "These are areas for investors to consider going forward as they look at new issues," he says.
Fitch's Katz notes that ratings take a lot of scenarios into account. "We take pricing speed if it's a new issue deal, or a last-six-month average if it's a seasoned deal. We run it at pricing speed, at 200% and again at 50%," she says. "This process really covers [all scenarios], because we use the pricing speeds in the market. The absolute number moves."
"Keep in mind that there is not always liquidity, so if you're buying something highly structured and you paid a premium for it, you need to consider this," adds Va1 Goldstein, an ABS consultant for Structured Risk Advisers.
"Often, transactions that are complex have a potential for some kind of shock. For example, if there's a drop in real estate, [ABS CDOs] will all behave the same way, so there may not be as much liquidity as you would think," Goldstein says.
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