Investors looking to exploit the newly volatile home equity ABS sector are expected to be among the catalysts for the growth in a relatively new CDO structure, combining both funded and unfunded assets and liabilities, to hit the U.S. market.
Although a standard definition for the structure does not yet exist, industry participants estimate that some half dozen of these so-called cash and synthetic hybrid CDOs have come to the market so far this year. Rating agencies, for one, are anticipating market fundamentals to encourage more of these deals next year, with Fitch Ratings and Standard & Poor's both confirming that at least two such transactions are currently in the pipeline, for which Fitch is estimating arrival dates of December and January.
What makes the structures attractive and why an increasing number of these deals are expected to come to the market next year is the portfolio manager's ability to diversify assets while exploiting arbitrage opportunities between cash and synthetic pricing. The International Swaps & Derivatives Association's release of formalized contracts for pay-as-you-go settlement procedures has enabled CDO managers to model liability structures of synthetic deals after cash deals, causing a surge in the structures that started in the second quarter, according to S&P Director Belinda Ghetti.
"The use of synthetics in the context of a cash CDO of ABS enables easier collateral selection and sourcing, and a more efficient liability funding cost," Ghetti said. Most hybrid transactions exhibit the same cash CDO structural features - such as collateral quality tests and diversion triggers - of fully funded cash CDO of ABS, but the major difference is the use of an unfunded super-senior tranche in the capital structure, which introduces a cheaper funding source for the CDO, Ghetti added.
Banks as well, in preparation for Basel II, are expected to constitute another source of growth in the sector, as they look to synthetically remove double- and triple-B rated asset exposure from their balance sheets in order to avoid an increase in risk-weighted capital requirements. And while so far, this structure has primarily referenced RMBS, the soon-to-arrive credit default swap index for collateralized mortgage backed securities could further enhance commercial real estate CDO structures in the same way.
Albeit growing rapidly, the still green and relatively shallow RMBS default swap secondary market is much more sensitive to fluctuations in not only investors perception of risk but supply and demand fundamentals, said one analyst, creating a number of arbitrage opportunities with the securities' cash counterparts as pricing changes, according to analysts at JPMorgan Securities. For example, the spread differential between cash and CDS spreads for triple-B minus rated RMBS has ranged from as few as 25 basis points to as many as 125 basis points in recent weeks, according to Fitch. By creating portfolios with both cash and synthetic securities, portfolio managers are flexible to transition between the collateral types in order to exploit such fluctuations in pricing.
Hybrid deals currently in the pipeline primarily reference triple-B rated RMBS collateral, said Fitch analyst Priya Baveja. Deals' average portfolios contain 60% to 80% concentrations of synthetic CDS referencing RMBS collateral, with the remaining portion of the portfolio consisting of cash ABS assets, according to a recent report authored by Baveja and fellow analyst Tania Cunningham. Various classes of senior and subordinate cash notes act as credit enhancement for an unfunded synthetic super-senior revolver, which is paid a CDS premium.
Cash amortizations pay down the drawn portion of the revolver first, ensuring that losses from the synthetic portfolio are transferred to the lower rated cash notes. One potential consequence of the collateral mix - the risk that the underlying cash RMBS collateral may fail through prepays or other scenarios to provide a steady cash flow toward paying down the revolver - is generally taken care of through one of several cash reserve methods.
One of the hybrid CDO structures that came to the market this year, State Street Global Advisors' Pascal CDO Ltd., has a $1 billion reference portfolio consisting primarily of high-grade ABS and includes a total return swap with The Royal Bank of Scotland and a senior swap with Ambac Credit Products.
So far, credit enhancement requirements for the hybrid deals are generally slightly higher than their pure-cash counterparts, Baveja said, because of the complex and yet-untested nature of the structures, although that is expected to change. "Bajeva added that the future use of different asset types in hybrid structures, such as CMBS, will depend on liquidity in the synthetic market.
Because of proposed Basel II implications, highly rated banks can convert balance sheet assets from an average triple-B rated CDS to a triple-A rated CDS, reducing risk weighting from 100% to 20%, according to Baveja.
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