As evidenced by the growing CDS of CDO market, investors are becoming increasingly bearish on not only subprime mortgages issued in 2005 and 2006, but also on the CDOs that are buying the bonds backed by them. While rating agency sources say the first downgrades to these CDOs shouldn't be expected for several years, investors are expected to begin asking for more risk compensation before they buy the lower rated notes.
Twenty-seven CDOs totaling $15 billion priced in the week leading up to Information Management Network's ABS East conference. Triple-B mezzanine SF CDO spreads for the four such deals that priced widened by an average 15 basis points, pricing at 340 basis points over Libor, according to JPMorgan Securities. Triple-B SF CDO tranches, on average, widened five basis points in the month of October, closing at 335 basis points over Libor, while double-B tranches gapped out by 10 basis points, according to Deutsche Bank. Both are at 52-week wides.
Thanks to the use of synthetics, CDO issuance is flying with its own wings - no longer constrained by the actual rate of the debt issuance that it buys. CDO issuance has grown 86.2% this year versus the same period in 2005, according to JPMorgan analysts. In fact, if CDO issuance data was removed from overall ABS issuance, the sector would actually be posting a 1.8% year-over-year volume dip, compared to its current 10.8% increase over 2005.
The recent bout of synthetic HEL spread widening brought on by hedge fund protection buying has only furthered the CDO machine, but with continued negative data plaguing the housing sector, some are beginning to wonder if the cycle might slow. CDOs closed in the first half of this year averaged a 64% concentration in U.S. subprime mortgage product, compared to 48% during the same period in 2005, according to Derivative Fitch. Moreover, buckets for the products have grown to 75% to 100% in recent deals, compared with 60% to 80% last year.
But downgrades are not anticipated to hit the CDO sector, at least for the more recently originated deals, for several years. "We certainly see things happening in the 06 vintage RMBS, but since it has to work through the RMBS transactions first, if this negative performance continues, I don't see it affecting the 06 vintages CDOs until 2008," said Kevin Kendra, senior director in Derivative Fitch's structured product group.
Subprime mortgages originated in 2006 are posting what appear to be record 60-plus day delinquencies. In fact, the rate of delinquencies these loans are experiencing at such an early age is higher than mortgages originated in any other year, according to Lehman Brothers.
Standard and Poor's late last month downgraded several triple-B tranches of deals from Lehman's Structured Asset Securities Corp. shelf - but the deals were issued in 2005. The 2005-S4 deal's B class was downgraded to double-B from triple-B minus, while the 2005-S5 deal's B-3 class was downgraded from double-B to B; its B-4 class was downgraded to triple-C from double-B minus. Both of the deals were issued less than 14 months ago.
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