Like gamblers to Las Vegas, investors are pouring into the derivatives markets in the hopes of winning the jackpot - that is, placing the right bet on the ability of U.S. consumers to make their monthly mortgage payments in a slowing housing market.

But the bet is not simply a matter of whether borrowers, mainly those with poor credit, do indeed default on their loans. Rather, it is a calculation of how many defaulted loans it will take to bring the first dollar losses to securitizations backed by them, how long that will take and how the secondary market will react, among other factors. The gamble, of course, is trying to balance the cost of making this short bet on the market with the expected payout, market participants said last week at a lunchtime conference sponsored by UBS in New York last week.

The amount of cash flowing through the trading desk at UBS for ABX.HE trades alone has doubled 2.5 times since April, said UBS ABX trader Alex Pritchartt. The triple-B and triple-B minus index tranches constitute 80% of activity, he said. "For macro hedge funds, ABX is the product of choice," Pritchartt said. In fact, there is enough ABX triple-B minus volume on UBS's trading desk in a single day to account for the entire notional amount of the underlying bonds.

The sheer amount of cash homing in to short the index has made it costlier to do so. Spreads both for index products, as well as single-name derivatives and cash have begun to widen. Since Labor Day, triple-B minus ABX spreads have gapped out to 270 basis points, compared with about 215 basis points in late July, according to UBS.

But even amid the widening frenzy, the market could turn quickly if this group of fickle investors rushes to unwind trades amid a slightly more optimistic housing market outlook. In fact, Bear Stearns analyst and Senior Managing Director Gyan Sinha warned investors last week not to "bet the farm" on a particular set of outcomes for housing.


While CDO managers, naturally the protection seller and ying to the macro hedge funds' yang, are welcoming the wider spreads with open arms. Some are beginning to question the viability of the bifurcated CDS market, which has been dominated by the game of tug-of-war between the two parties. And others are beginning to ask: Have credit fundamentals flown out the window in favor of a game of relative, not actual, risk?

Market participants last week also questioned whether dealers could be stuck carrying the trades, which in UBS's case average a 100 basis point divergence in credit enhancement depending on which names its customers are selling or buying protection on. "We are buying protection on the same names over and over and over that have been selected by the CDO managers, and typically those that the Street has sold protection on were the opposite - so it is actually a fairly bad basis trade that the Street has on right now," said Jack McCleary, head of U.S. trading and syndicate at UBS. Deutsche Bank traders chimed in last week by saying that, "dealers caught on the wrong side of hedge fund protection buying are scrambling to cover long position in weaker RMBS names."

While dealers are hoping that January's inception of tranche correlation trading will help to mix things up a bit, the two main players in the single-name and index markets are not likely to fade away entirely anytime soon, and they certainly won't do so at the same time. "CDO managers feel like, yes, there may be a housing correction,' but through asset selection, they can put a portfolio in place that can weather a housing downturn," McCleary said, adding that managers need to keep fee income flowing by producing more deals. "The CDO manager is looking at the asset as its ability to provide spread to a sector for arbitrage, and the CDX buyer is looking at is a lottery ticket." Pritchartt also pointed out that the market does extend beyond the two main players to include equity and emerging markets clients, among others.

The best line of action

So what was advised? UBS last week recommended investors make trades both in the single-name and index markets. Also, when looking to buy single-name protection, do so using midtier names, so that there will be enough secondary market liquidity available to exit the trade if needed. More hedge funds are also helping to soften the negative carry of protection buying by going long CDO equity and short other parts of the capital structure. And even though most liquidity - 75% to 80% - is concentrated in the ABX.HE-2 series - thus making these spreads wider for arguably fundamental as well as technical reasons - shorting the ABX.HE-1 series could provide "significant value," Pritchartt said.

Meanwhile, Bear Stearns's Sinha also noted last week that short players should hedge their bets with a long leg. "In this way, investors are likely to capture changes in the relative pricing of risk within the capital structure without having to bet the farm on a particular set of outcomes for housing." Sinha suggested the "blood bath in housing" may be coming to an end, citing a statement to that effect by former Federal Reserve Chairman Alan Greenspan, along with the recent surge in the Dow Jones Industrial Average and a drop in mortgage rates, among other indicators. Sinha also warned of a flood of investors looking to unwind their trades, a move that would result a sharp short covering-related spread tightening.

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

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