The torrid pace of deals churning from the industry coined "CDO machine" this year is making last year's record issuance look like a warm-up round. Total dollar volume in the U.S. CDO market was up 96% in the first eight months of this year compared to the same period last year, according to Deutsche Bank. The number blew past the broader ABS market's feeble 0.05% gain over 2005 issuance at this time last year.
The wave of CDO issuance has brought with it new asset managers, a broader base of investors and busy rating agencies - whose analysts have been taxed with judging the risk involved with a plethora of new structures and collateral types.
"Comparing the first half of 2006 to the first half of 2005 underscores the perception that expectations of usual' and normal' have undergone something of a sea change," Moody's Investors Service wrote last week. (The rating agency rated more transactions in the first half of this year than it has ever rated in any year period prior to 2005.)
But while a number of industry players - particularly CDO managers - would seem to point out that the volume gains prove the CDO market is "here to stay," Deutsche last week argued that some 40% of U.S. CDO issuance leading up to Sept. 1 was backed by leveraged loans; moreover, the option for synthetic issuance has essentially allowed issuers to tailor their securitization strategies to investor demand - instead of to actual collateral availability. Translation: in the minds of some, the rug could be pulled out from under the growing CDO market if investor interest in the U.S. real estate market abates.
"We are not believers that this is a new paradigm and that CDOs will now and forever have a permanent mark on the ABS market place," Deutsche analysts wrote. "The reality is that over half of current CDO volume is tied to the fortune of the U.S. residential real estate market." They added that, "as weaker housing fundamentals potentially translate into weaker protections to (home equity loan) bond holders, rising downgrades could take a lot of the wind out of the CDO sail."
Built on unstable ground?
Citing the rise and fall of two chapters in CDO history - the high yield bond CDO craze that ended along with the bursting of the tech bubble in 2000 and the notion that bonds backed by manufactured housing and aircraft loans presented promising collateral choices - analysts at Deutsche last week questioned when housing market performance might decline enough to make RMBS-backed CDOs conclude chapter three.
The residential mortgage loan market, particularly newly originated subprime loans, appear to be coming under pressure. According to the Office of Federal Housing Enterprise Oversight, average U.S. home prices rose only 1.17% in the second quarter compared with 3.65% a year earlier - representing the largest drop in value since 1975. Additionally, the "broadly defined" real estate sector is responsible for some 44% of jobs created since 2000, employing one-in-10 U.S. workers, according to Moody's.
In light of the implications on the housing sector and the broader economy, are structural protections built into RMBS-backed CDOs enough to help them weather a downturn in the market? It depends on who is asked. "To the extent appreciation does not hold, we are going to see borrowers underwater," said one CDO trader with negative views on the viability of the sector. "If there is no juice in it for them, it could make it less difficult for them to walk away," he said, pointing out that a number of ABS deals backing the CDOs are structured assuming certain housing appreciation rates.
Yet, asked six months ago, Armand Pastine, a managing director at Maxim Group said what a number of asset managers, such as Trust Company of the West, still firmly believe: "Absolutely. The empirical performance of this sector is second to none. And I think (RMBS-backed CDOs) should be more dominant than CLOs. I think, fundamentally, the mortgage market is an extremely efficient, well-priced market right now. There really isn't much risk at the top of the capital structure in these RMBS deals." (ASR, 03/06/06) And, generally, rating agencies and analysts tend to agree with that sentiment today - barring, of course, widespread economic deterioration.
"While specific consequences to real-estate dependent CDOs are generally being anticipated in sizing subordination levels ... the macro consequences to the economy from an abrupt slowdown in real estate continue to occupy the attention of forecasters and structurers," Moody's wrote last week.
Time will tell
Additionally, many speculate that an actual "popping" of the housing bubble, in the manner of the tech bubble bursting, is impossible. "Unlike corporates, changes in the performance of consumer finance collateral due to borrower behavior unfold slowly overtime. A changing housing climate will ultimately lead to more downgrades; however, these long lags mean that the pressure on CDOs will not come anytime soon," Deutsche wrote.
If real estate does fall out of favor, leveraged loans seem primed to take their spot as the collateral of choice. CLOs comprised 31% of all transactions rated by Moody's in the second quarter- an increase of more than 110% from the first quarter.
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