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.
High-grade deals also include a super senior tranche, which can account for more than 85% of all liabilities issued. "Given the highly levered nature of these deals, even small variations in the capital structure can have a very significant impact on equity returns," Deutsche analysts wrote. Those variations stretch from new asset types appearing within high-grade deals to basis risk between benchmark indices.
Deutsche analysts found four issues regarding cash flow modeling assumptions embedded within high-grade ABS CDOs. The issues are not likely to impact debt securities, but could - particularly because of the highly levered nature of the deals - affect equity returns. Using a high-grade ABS CDO model with a 0.95% equity tranche, the analysts found that the combined effect of the four assumptions could result in an equity return of only 10.2% - down from an expected return of 19%.
Because high-grade deals are typically backed by RMBS assets, which pay monthly - as do most super senior liability tranches - quarterly pay assumptions built into models could result in errors. Secondly, basis risk between one-month and three-month Libor could also present itself in some pre-2004 deals, Deutsche found. A number of deals during that time period were funded with quarterly pay securities indexed to three-month Libor, while the assets were indexed to one-month Libor. Third, asset managers have been sprinkling in higher yielding, yet still highly rated securities such as cap corridor bonds and pass-through hybrids into portfolios. Because of more complex interest terms and prepayment profiles, these "alternative prime" products could throw off some models. And lastly, if there is a lapse between the asset and liability payments for the first payment, equity holders in highly levered deals could feel it through reduced equity proceeds in the first period. Delayed ramp-up could have negative implications on first period payments as well, Deutsche analysts pointed out.
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