LAGUNA NIGUEL, CALIF. - The towering wall of liquidity that continues to prop up the U.S. CDO market could begin to crumble in 2006, as credit concerns over the health of the residential housing and corporate credit markets begin to sour investor appetite, said participants at this year's Opal Financial Group CDO Summit held here last week.
"Liquidity is going to drop. It's not a question of if,' it is a question of when,'" said Evan Kestenberg, a CDO trader at United Capital Markets. And while some pointed to signs of widening spreads in triple-B minus rated home equity ABS tranches as evidence that investors are beginning to put less value in those bonds, others say it was evidence, rather, of the influence that hedge funds now wield over the sector. Indeed, some are concerned that liquidity could evaporate, given that many believe the U.S. housing boom is at least partly driven by this group of flighty investors.
Hedge funds up volatility
The rush of hedge fund buyers, who were eager to be among the first in line to efficiently short the home equity loan sector through the credit default swap market, was what caused the recent volatility in the lowest-rated tranches of cash home equity ABS, said Jason Golush, a senior vice president at RBS Greenwich Capital. Until several weeks ago, when the CDS of ABS market gapped out dramatically, the cash sector had remained relatively stable for many months - despite plenty of negative media regarding the specter of a U.S housing bubble.
Jason Schechter, a senior vice president and head of CDO trading at Lehman Brothers said about 60% of the investment bank's customers are now comprised of hedge funds, "and it is going to continue to explode in 2006," he said. "What concerns me though is: is this liquidity here to stay, or are we at risk for a sizable downturn?"
According to Steven Ricchiuto, chief economist at ABN Amro, liquidity can, and has, dried up over night. "The tech bubble was nothing more than the California utility crisis bringing down the commercial paper market," Ricchiuto said. When banks tightened commercial paper covenants, utility companies were forced to downsize growth outlooks, coincidentally prodding equity investors to sell stocks and the tech bubble to collapse, he said.
This scenario could repeat itself in housing, with higher short-term interest rates pricking the bubble in much the same way that tighter lending rules sent the tech sector tanking.
Andreas Jobst, an economist within the international capital markets department at the International Monetary Fund, said that movements within the CDO market do indeed drive economic research. Jobst said the increasing global cash surplus has worked to amplify tight spreads within the CDO market caused by the limited supply, and that such pricing movement "lets us know what needs to be fine tuned."
Exporting mortgage risk?
Jobst argued that the greater diversification of mortgage exposure risk spread throughout the world could increase financial fragility. Government sponsored entities Fannie Mae and Freddie Mac, for example, have reduced their investment portion of the U.S. MBS market from 53% in 2003 to 34% in 2004, and U.S. commercial banks and REITs hold only 35% of the assets. Jobst wrote in an accompanying presentation that the "two-pronged regulatory implications" would be to "facilitate qualified mortgage borrowing at higher rates and closer scrutiny of portfolio choice of investors."
Some, including Ricchiuto, feel the Federal Reserve Board will continue to raise interest rates - even through an inverted yield curve - in order to dry up cash supplies. What happens to CDOs as a result of that is a matter of substantial debate.
"Financial markets right now are priced at perfection, and I think that's a huge mistake," Ricchiuto said. Some, such as Jeffrey Prince, a vice president at Citigroup Global Markets, say it would take an enormously "dire situation" for even the lowest rated home equity bonds to eat through credit enhancement. "We at Citigroup do not see this as a catastrophic decline - this is an unfounded fear in the market," he said. "I will tell you that when I speak to investors, I am always surprised at how bullish they are."
And Lynn Hopton of Riversource Investments said that already locked-in low financing rates give CDOs a lot of extra cushion in case defaults do increase substantially. "I think that when you look at the leverage factor, it gives managers a lot of room to play with," she said. "Your arbitrage does stay locked in and will improve."
That is, if managers choose collateral wisely. "You have to be willing to accept lower spreads and get your allocations," said Steven Oh, a managing director at AIG Global Investment Corp. Oh said the mentality is to buy an attractively priced, high yielding security for six months and "getting out before the next guy."
"It's very tempting when you have cash coming in to say I'll reach a little bit more,'" added David Sachs, a principal at Ares Management. Conference participants admitted that it was difficult to remain disciplined on the heels of a three-year bull market, but going forward, it will be restraint that will differentiate the good CDO managers from the bad.
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