LAS VEGAS - This year's release of tradable indices for asset-backed securities credit default swaps - deemed the wild, wild West of ABS - is not only considered a turning point for the rapidly growing CDS of ABS sector, but is thought to be one of the most, if not the, monumental developments in the market, according to attendees at the ASF 2006 conference held here last week.
The ABS CDS market was jump-started in June 2005, when the International Swaps and Derivatives Association released standard documentation for pay-as-you-go and cash settlement procedures. An army of investors swooped into the single name swap market, enticed by the opportunity to take a short position on the subprime housing sector. And when the ABX.HE indices were unveiled last month, more roadblocks to participation in the market were knocked down, causing another surge of liquidity.
"The first day [of trading on the ABX.HE] was like the wild West," said Scott Eichel, a director at Bear Stearns & Co. "I felt like a 10-year Treasury trader. The volume was unbelievable."
Most ABX.HE investors so far are displaying interest in the bottom of the capital structure where risk and returns are higher. Heavy demand for protection in the area pushed spreads on the lower-rated indices out while the triple-A index began trading inside cash spreads. The curve steepened by about 15 basis points in the first day of trading, said Michael Swenson, head of ABS trading at Goldman Sachs & Co., who participated in a panel discussion at the conference.
Poll reveals interest in the sector
Forty-three percent of audience members polled during a panel discussion said they plan to consider investing in the sector in 2006 and 27% had already invested. Only 30% said they were not interested.
"In just 18 months, the market has become big, I mean real big," Swenson said.
Part of the draw for investors is the new versatility provided by the products.
"Previously, if you didn't like the credit, you couldn't do anything about it. But now you can short it," said Zain Abdullah, a managing director at Calyon Corporate and Investment Bank.
While a host of hedge funds and other types of investors are very interested in the products, the CDO sector, which has become increasingly heavy with residential mortgage-backed securities collateral, has been a major beneficiary of increased ABS CDS liquidity. The sector has seen what appears to be a record number of first-quarter deals. Instead of standing in a long line of other investors, managers are now able to ramp up deals faster than ever with a broader selection of collateral.
Most ABS CDO deals in 2006 are expected to incorporate synthetics.
"It amazes me that people are still even doing cash deals. Why would you want to purchase cash bonds and worry about mark-to-market liabilities?" Eichel asked.
Losing market value is a risk
The process of accumulating enough collateral to ramp up a CDO can take more than a year, during which time accumulated assets face the risk of losing market value or early defaults, Eichel said.
Rating agencies are starting to see the first inquiries from CDO managers interested in incorporating the ABX.HE index into the structures. The idea has faced skepticism. Because CDO managers are charged with picking the best collateral, simply referencing the index doesn't seem like the ideal situation, conference attendees said. However, options could include shorting the index and going long specific single name swaps.
But as Abdullah mentioned, there are several issues regarding ABS CDS trading and settlement procedures that have yet to be ironed out. Among the most common criticisms: many have complained that deal terms are more favorably weighted toward sellers of protection than buyers of protection; and each investment bank seems to be using a slightly different settlement contract than the next.
Pacific Investment Management Co. has between 30 and 50 accounts with exposure to the index, according to vice president Josh Anderson. Though the company is involved in the index, Anderson voiced several concerns with the ABS CDS sector.
Several industry players discussed various elements of uncertainty in the market. Aside from contractual issues, Anderson and others mentioned the specter of manipulation that playing in ABS CDS can introduce.
"When it was a long-only market, you knew where everybody stood. But now ... it is not so clear," Anderson said.
Some questioned where the line would be drawn between standard market practices and manipulation. For example, buying protection on one's own bonds could introduce an incentive for those bonds to perform poorly.
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