A broader base of capital market constituents, including equity investors, have new routes available for taking views on credit risk, thanks to the recent launch of two new credit derivative indices harnessing real estate collateral. But while the growth of credit default swaps is a milestone of the modern market's landscape, some wonder what the new indicies will bring for the markets underpinning those swaps.
It may appear the new indices cater just to the structured finance crowd, but the launch of ABX.HE in January, and CMBX, launched last week, has attracted a wide array of interest, say dealers, including market participants who trade equity indices.
"Investor interest is very high," said Chuck Mather, a CMBS trader at Banc of America Securities. "We are receiving a lot of calls and inquiries around the specifics of the trades, how it works and how it is modeled."
While hedge funds and whole loan originators man the front of the bandwagon, market dealers believe, basically, that any investor holding a cash bond in home equity or residential real estate, or a position in commercial real estate, will eventually use the new indices.
"People are always looking for a more standard way of trading and gaining exposure, whether that would be the long or the short, and an index allows for that," said Todd Kushman, a product specialist in ABS derivatives at Bear Stearns.
Both indices offer credit default swaps on collateral from the real estate market.
ABX.HE is an index of home equity loan securitizations and is laid out across five sub-indices defined by rating categories, triple-A down to triple-B minus. Twenty recently issued HELs comprise each class of sub-indicies.
Harnessing commercial mortgage backed securities, the CMBX is similar in many respects. But it indexes 25 recently issued CMBS securitizations. Both the ABX.HE and CMBX use a market participant polling method to arrive at which deals to include, and a new series is introduced every six months, called a roll.
Trading on the ABX.HE index has been moderate. Nomura Securities research shows the first day of trading saw about $5 billion in trading volume and dealers say the volume has been steady.
"There is some concern as to if the players of the CMBX are more fast-money.' That could add volatility to our spreads," said Darrell Wheeler, managing director, global head of CMBS strategy at Citigroup.
Wheeler said as the new index investors come to understand more about the structure and stability of CMBS collateral, they will be less likely to react as much as they have in single-name corporate CDS.
"But I think everybody should be mindful that the credit derivative market is a new market that is developing. It's tough to track the size of the market and from that standpoint, we, as cash buyers in this market, watch cautiously the development of this product," he said.
Researchers seem to agree the indicies add more than they threaten to take away.
"It could prove a very successful tool as it has for other markets. The index is very transparent and it could grow to be liquid," said Roger Lehman, managing director and co-head of structured credit research at Merrill Lynch. "Still, it's important to understand how they work and that the indices mimic the underlying cash bonds."
But the relationship of indices with the CDO market is another area buzzing with inquiries. CDOs are still considered largely buy-and-hold securities, so it is still unclear what to make of that when juxtapositioned against a fairly liquid CDS landscape.
Sources at the rating agencies say they are contending with questions over CDO methodology in the wake of the new indices. The possibility has been raised that new CDOs might tap an index during the CDO ramp-up period.
Sources from the investment banks point out there is a valid argument for using an index during the CDO ramp-up period in an effort to source collateral, at least in the short term.
However, should that happen with increased frequency, CDO ratings might have to change. If enough CDOs start using the index, either during ramp-up or as part of the deal permanently, collateral assumptions for ABS CDOs might have to change.
Collateral managers are wondering what the impact will be on cash CDOs, the traditional CDO structure where actual bonds are purchased and held by the vehicle. What if investors tire of paying CDO managers for their credit expertise and move to purchase securities from the index instead?
"It's not gong to put a manager out of business. It's simply another way for investors to get exposure to the marketplace on a diversified pool," Kushman said. "There will always be cash and synthetic structures."
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