Amid a downturn in the U.S. housing market, a number of investors would shy away from pouring money into securities backed by subprime loans - much less the riskiest part of a mezzanine CDO backed by those bonds. But CDO equity tranche investors in this scenario could be paid long enough, at a high enough rate of return, to make the purchase worthwhile, according to Citigroup Global Markets.

Using its own models to assume loss, prepayment and delinquency projections for subprime loans, the investment bank wrote, in research released last week, that most subprime bond defaults will be back-loaded, creating a relatively long period of time before losses are realized. Citi is recommending that would-be equity investors seek out a well-managed deal backed by a geographically broad pool - and a rate of return in the range of 20%. Of course, the timing of the cash flows and their size are primary factors in the viability of the investment.

"The back-ended default profile of subprime (mezzanine) bonds, even in a severely stressed housing price scenario, implies that early cash flows are relatively robust," Citi wrote, "Although the advertised returns may be greatly diminished, a CDO investor in a high-(internal rate of return) equity tranche is liable to receive much of the initial cash outlay before being cut-off." A portion of that return, however, is factored in to be made near the end of the transaction's life through situations such as a collateral sale - making the CDO manager's skill and experience with trading out of bad positions key in choosing which deal to invest in, Citi analysts wrote.

Citi anticipates a gradual slowdown in the national rate of home price appreciation from roughly 11% currently to 5%. But using a more bearish scenario, its analysts found that in an environment of negative 5% home price appreciation, a pool of 82 bonds from 22 subprime deals from the latter half of 2005 would by-and-large not begin to default for at least eight years. The bonds in the scenario had an average rating of Baa3 and Baa2, with one-fifth rated noninvestment grade by either Moody's Investors Service or Standard and Poor's. Citi found that not all bonds extend even with a default, and the highest chance of extension is not directly correlated with the lowest-rated class.

Following a comparison of the bearish, high default scenario with an identical deal modeled to have zero defaults, Citi analysts found that equity investors in the latter scenario would only have several months to earn back their initial investments through returns.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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