Cash flow models may not be keeping up with the rapidly growing and transforming high-grade ABS CDO sector, according to a report released last week by Deutsche Bank analysts. The U.S. high-grade ABS CDO sector has grown exponentially in recent years - to roughly $40 billion year-to-date from about $42 billion in all of 2005, and some $5 billion two years earlier - primarily due to demand on behalf of some investors for "safer," higher-rated portfolio assets. The deals now represent two-thirds of the entire structured finance CDO market, Deutsche said.
High-grade ABS CDOs are generally backed by assets rated single-A and higher, meaning they must be structured with a higher degree of leverage than a typical mezzanine CDO in order to generate meaningful returns. That translates into a shrinking equity tranche. While a typical mezzanine ABS CDO would have an equity tranche of about 4%, or 25 times levered, its high-grade counterpart might have only a 0.5% to 1% equity tranche or smaller - meaning the deal could be levered 100 to 200 times, Deutsche reported. For example, the $997 million Buckingham CDO I, issued a year ago and managed by Deerfield Capital Management has only a sliver of an equity tranche at 0.3% and a 27 maximum WARF. Likewise, TCW Investment Management's $2 billion Davis Square Funding VI came to the market in March with a 0.5% equity tranche.