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.