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.
That idea seems to be the consensus. "What could happen in 2007 as a result of deteriorating performance is a weakening of the CDO bid,' which impacts overall liquidity and further impairs the resi-ABS market," said one source, pointing out that while deteriorating performance may not immediately result in principal losses to ABS collateral, deteriorating performance could lead to ABS CDO paper trading below par. That means investors could end up sitting on money -losing paper, he said.
Triple-B mezzanine CDO spreads were widening as of press time last week, according to market sources, up from 370 basis points over Libor as of Jan. 18. Triple-B spreads were 375 basis points over Libor the previous week.
Failed CDO triggers unlikely this year
Despite all the exposure to troubled HEL collateral - at least at the low end of the capital structure - Lehman is not expecting an abundance of failed triggers this year. Declines in overcollateralization, however, are expected to hit 2005 and 2006 CDOs the hardest. For example, the 2006 vintage has an average OC coverage test of 102.3% and current OC of 104.8%. Lehman estimates the OC would drop to 104.1% post-downgrades in the underlying collateral - leaving just 1.8% of a cushion by year-end. Meanwhile, the average subordinate classes within the 2003 vintage mezzanine CDO would enjoy a 5.1% cushion under the same scenario.
Lehman earlier this month estimated that home equity loan downgrades could increase by three to four times this year compared to the second half of 2006. Such an increase would mean as many as 1,500 bonds could be at risk for a downgrade, given a 0% to 5% national rate of home price appreciation, the investment bank's analysts wrote in a research report. While the number of relatively new deals piling up on rating agency watchlists is unprecedented - and there seems to be a consensus that the 2006 vintage is, in fact, the worst ever - a number of sources are expecting the amount of downgrades of 2003 and 2004 vintages to take the market by surprise. In fact, 50% of triple-B securities closed during those years are due for a downgrade, given a 5% national HPA scenario. Problems are arising in 2003 and 2004 deals due to a combination of low excess spread, embedded basis risk and weak triggers, Lehman analysts wrote.
According to Fitch Ratings, 2003 vintage mezzanine bonds are expected to come under "severe downward rating migration pressure" this year, similar to what the 2002 vintage experienced in 2006. Because the majority of the deals are past their stepdown dates, the remaining principal balance of mezzanine bonds could be more vulnerable to increasing defaults and delinquencies, Fitch said. While delinquencies and defaults are high enough in those loans originated in the latter half of 2005 and 2006 to warrant downgrades in the first half of the year, Fitch is not expecting those downgrades to surpass one or two notches.
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