The majority of outstanding mezzanine CDOs will experience HEL downgrades within their portfolios this year, Lehman Brothers researchers wrote in a report last week. Given an environment with 5% home price appreciation, roughly 90% of mezzanine CDOs originated between 2003 and 2006 will have exposure to HEL bonds due for a rating agency downgrade, the researchers said. What's more, one-fifth of outstanding mezzanine CDOs have 10% or more exposure to the expected downgrades, and in a flat HPA scenario, roughly 30% of outstanding CDOs would have a 10% or higher exposure.

As the industry-coined CDO machine has continued to pump out deal after deal backed by subprime collateral, in effect funding subprime origination, market participants have grown increasingly wary of how the deals will fare as the U.S. housing market turns. While few analysts seem to believe CDOs will actually take principal losses in 2007, trouble in underlying collateral could lead to a faltering new issue pipeline and downward pressure in the secondary market. "If HEL collateral deterioration persists and losses prove to be higher or more back-loaded than widely expected, collateral rating downgrades might cause CDO spreads to re-price and issuance volumes to moderate," Barclays Capital analysts wrote last week.

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