Some view spread widening in residential real estate CDOs as a buying opportunity
Issuance of collateralized debt obligations backed by mortgage and home equity loan-backed securities reached record levels in 2005, with both the number of transactions and volume more than doubling. However, jitters over signs of possible downturns in pockets of the real estate market, most importantly on the residential front, are muting the celebration.
"CDOs backed by real estate ABS have performed very well over the last few years, but we are hearing a lot of noise about whether we're in a housing bubble or not, and it's a fair concern," said Sanjeev Handa, head of ABS and CDOs at TIAA-CREF, one of the largest investors in CDOs.
Indeed, the collateral of existing real estate CDOs continues to perform superbly - rating agencies have yet to downgrade a single CDO backed entirely by real estate assets. However, concerns about the state of the housing market have caused spreads among structured finance CDOs to soften recently. Mezzanine structured finance CDO spreads gapped out by roughly 120 basis points in November before recovering about half of that in December.
U.S. cash flow CDO issuance remains robust, with $115 billion in new CDOs issued last year, up about 88% from $61 billion in 2004, according to Fitch Ratings. CDOs backed by asset-backed bonds are among the fastest growing subset in the market, and a good chunk of that is real estate CDOs. Standard & Poor's rated 95 ABS CDOs that were issued in 1995, 20 of which were real estate CDOs. That is up from 80 ABS CDOs in 2004, nine of which were real estate vehicles. Excluding synthetic transactions, S&P estimates that $8.02 billion in real estate CDOs were issued in 2005, up from $3.2 billion in 2004.
There is some trepidation about CDOs backed by commercial real estate loans, but for now market participants seem most anxious about residential collateral, which account for the majority of real estate-backed CDOs. A vice president at a hedge fund active in CDOs, who declined to be named because his firm is in the early stages of ramping up its own CDO, said, "I have concerns about both [collateral types], but I think residential may be a bit more overdone."
Secondary CDO traders at two different dealers report an increase in calls from investors asking if they see signs of slippage in deals backed by residential mortgage loans. "It's where the focus is," said one. "Housing prices are showing signs of depreciation and investors are expecting something to give."
Residential real estate CDOs are particularly vulnerable to declining home prices, so should the market stumble, there are fears of widespread downgrades. "I think there is a residential housing bubble in some areas-significant housing price appreciation, for example-so you have to be careful," said Handa. Investors in subordinated tranches of real estate CDOs have to remain especially cautious because, "not only are you taking on exposure to the residential market, your exposure is on a leveraged basis to a particular tranche," Handa added.
A decline in the value of the underlying assets could trip triggers in many CDOs. "If those financial triggers are breeched, there are adverse consequences to those investors," says Joe Suh, co-head of McDermott Will & Emery's structured finance group. "Furthermore, CDOs with significant subprime mortgage-backed securities will get hit hardest."
Market participants estimate that some $100 billion of subprime mortgage loans have been packaged into CDOs. According to Fitch, over the past few years, subprime paper has gone from accounting for less than 50% of structured finance CDO deals to 80% or more.
Several CDO investors stated that they are watching real estate markets in areas of California and in Las Vegas for early indications of trouble because significant pools of subprime loans were originated in those areas. The stability of subprime paper has "varied over time," said Glenn Costello, co-head of Fitch's RMBS group. "In the last few years, a benign environment-low rates, rising home prices, strong economy-has made for stable performance."
To the largest CDO underwriter on Wall Street, an air of concern may have penetrated the market, but that's about as far as it has gone. "We haven't seen many actual bad results in the mortgage markets - it has all just been worries about it," said Chris Ricciardi, head of global structured credit products at Merrill Lynch, the top CDO underwriter in 2005 with over $25 billion of US CDO volume via 38 new issues, according to Thomson Financial. Furthermore, most investors in senior CDO tranches are more insulated from a downturn due to the additional credit enhancement of a CDO structure relative to a plain home equity loan-backed bond, Ricciardi added.
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