As RBS Greenwich Capital analysts put it last week, "it has been a while since we last saw it, and new investors in the sector may not recognize it. Volatility has returned to HEL credit." The volatility is a result of pricing fluctuations in the home equity ABS credit default swap market, the cause of which is not entirely clear.
Buckling under the pressure of the tempting wide margin between some of the lowest rated cash and synthetic home equity ABS exposure, it would appear as though CDOs, among others, have finally moved in as protection sellers in the asset class. Although, another possibility for the dislocation seen in the home-equity CDS market in recent weeks could be the result of a rash of hedge funds unwinding short positions.
According to JPMorgan Securities analysts, protection selling the preceding week helped draw in home-equity credit default swap spreads, which had widened dramatically. The triple-B minus basis tightened by 20 to 30 basis points, according to JPMorgan, while the basis at triple-B levels remained wider, in the 10 to 20 basis point neighborhood. Credit Suisse First Boston estimated the spread reduction for triple-B minus default swaps settled in at 260 basis points, in from 325, with triple-B synthetics tightening 15 basis points, to 175 basis points from 190 basis points. The synthetic widening had also helped to push cash home equity ABS spreads wider, a move expected by some to reverse itself.
For some, the movement is a breath of fresh air. The wider spreads have significantly improved arbitrage opportunities within mezzanine classes of structured finance CDOs, which have seen historically tight spreads throughout the capital structure. Movement in cash spreads, according to JPMorgan analysts, has increased the equity funding gap - the yield on CDO collateral minus the cost of CDO liabilities, fees and expected loss - to roughly 60% of the estimated historical maximum return. And, using home equity loan default swaps instead of cash spreads in its equity gap funding mechanism, JPMorgan calculated that representative return increased to nearly 70% of the maximum historical estimated return for the sector. That calculation comes after increased liability costs, reflecting higher synthetic risks, are factored in.
The cash funding gap for mezzanine structured finance CDOs had dipped to roughly 40% of the estimated historical maximum return in October, but reached its lowest point in recent history in May, when it was some 8% lower, according to JPMorgan. In January 2004, the funding gap for the deals nearly reached the ceiling, at 90%, of the estimated maximum historical return.
While synthetic spreads are expected to continue compressing, as more CDOs and other market participants look to step in as protection sellers, in part through product innovation such as the hybrid cash and synthetic CDO structures, the possibility for arbitrage is still significant.
"These possibilities should lead to continued interest from CDOs in synthetic exposure, and continued near-term basis compression," JPMorgan analysts wrote. Additionally, CSFB analysts noted that cash spreads on triple-B minus floating-rate home equity ABS were about 90 basis points outside of tights reached in October, and triple-B cash spreads were about 30 basis points wider, even while CDS spreads move tighter. While the triple-B minus home equity classes have priced in the 170 to 180 basis point range for much of the year, the end of October saw spreads on those classes move out to 195 basis points, and, as of mid-November, were trading at 275 basis points, according to RBS Greenwich research.
CSFB added that spread tightening could not only be due to additional CDOs and others entering the market as protection sellers, but also, and potentially more likely, a result of protection buyers unwinding positions. "Given the expense of paying 320 [basis points] protection in the CDS market and the profit in the trade for first movers, protection buyers may look to unwind the CDS," noted CSFB analysts in a research note in early November. Because it would take at least two years - or about the minimum time period before any referenced home equity bond would remain in default long enough to trigger a CDS payment - before the home equity protection buyers would be able to collect any cash from the trade, CSFB predicted that there may be a "race to the exit at some point, when some of the protection buyers cash in."
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