An increasingly wide band of market players looking to express a shorting interest in home-equity ABS has ballooned the credit default swap market on the month to more than $4 billion in bid and offer lists - surpassing cash market volumes, according to Lehman Brothers, and gapping out spreads on CDS premiums by as much as 250 basis points. Most of the activity has occurred at the triple-B rated levels, and 90% of protection buyers have focused on the 2004 and 2005 vintages, indicating an overwhelmingly bearish view of the housing market going forward.
And while spreads are likely to retreat, Lehman Brothers still recommends buying, even at current levels, "due to the fundamental risks from a slower housing market." While performance statistics for the 2005 vintage home-equity ABS still appear to be in-line with the level of delinquencies seen at this time from the 2003 vintage, according to Friedman Billings Ramsey (see related story p 11), the expected slowdown in home price appreciation and rising mortgage rates are expected by many to add particular stress to mortgages originated this year, as subprime borrowers will find it more difficult to refinance.
Over recent weeks, the imbalance of investors looking to short the market and ability for sellers to match it has helped push the price of protection on triple-B minus bonds out by 40 to 60 basis points, to anywhere from a 225 to 250 basis point spread between the bond's discount margin and the CDS premium. That compares with a 10 to 15 basis point spread difference between cash and synthetic triple-B minus bond averaged over the last several months, according to Lehman. Lehman researchers estimate the fair value of the triple-B minus to CDS basis to be around 20 to 30 basis points, based on wider liability spread execution on synthetic deals.
Meanwhile, cash market spreads have remained stable at 175 to 200 basis point area over Libor, suggesting that the widening seen on the synthetic side may indeed be due not only to market technical factors but also to a barrage of volume stemming from the demand for protection.
The entire ABS CDS market has flourished in recent months, following the introduction in late June of formalized paperwork from the International Swaps & Derivatives Association in regard to pay-as-you-go contracts and settlement procedures, fueling the sector's widening acceptance and familiarity. Lehman estimates that roughly $1.7 billion in triple-B minus and $900 million in triple-B CDS has come to the market over the course of the last three months, and the market is continuing to grow as both traditional and non-traditional ABS investors seek to express a view on the market.
Most of the demand since mid-September has occurred on the triple-B and triple-B minus home-equity ABS, where 30% and 50% of CDS volume has focused, while 15% of activity came from triple-B plus rated securities. Only 5% of CDS have referenced the 2003 vintage, while 30% referenced 2004 and 60% referenced 2005 vintages. Deriving volume numbers by bid lists passing through Lehman's trading desk - divided by two to assume, conservatively, that only half of the bid/offer lists traded - derivative contracts referencing triple-B minus rated securities in September more than doubled actual cash issuance, and October's synthetic-to-cash ratio is more than four times.
Lehman expects the basis to begin tightening toward fair value in the medium term as CDOs increase their synthetic buckets, deal sizes, and triple-B minus concentrations. ABS CDO managers can layer exposure by selling triple-B minus protection, and, can actually benefit from the arbitrage by selling existing cash bonds versus selling protection on the same bond to replace it in the trust, Lehman advised.
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