With no crystal ball to guide them, market players are finding it harder to predict how 2007's unprecedented liquidity crunch might affect future European CDO performance.
Total European CDO volumes for 2007 are up from 2006 totals. The growth comes primarily from the more prolific first half of 07. According to figures reported by Merrill Lynch, the first half saw issuance up 102% from total volumes seen over the same period in 2006. At 59.8 billion ($87.7 billion), CDO issuance for 1H07 was slightly more than two-thirds of 2006 total volume.
Despite the first-quarter growth, the U.S. subprime woes negatively affected European CDO volume in the second half of the year. "Following the major change in the perception of risk that was brought about by the U.S. subprime crisis, demand for CDO paper all but dried up over the summer and well into the fall," Merrill Lynch analysts wrote in their European Structured Finance Annual Review. They added that the CDO market looked much different in late 2007 than it did at the start of the summer, with volume down sharply from the latter part of 2006. Specifically, November to December 2007 issuance was not expected to reach anywhere close to the 32.5 billion done over the same months in 2006, Merrill analysts noted. "Whether demand returns in the short- to mid-term will depend on improved transparency."
SME and leveraged loan CLOs led volumes in 2007, although rising liability costs and reduced arbitrage made funding via the capital markets less appealing during the second half of the year. According to market reports, the number of SME CLO deals was down 32% from 2006. But Deutsche Bank analysts said it is likely that the economics of bank capital regulatory relief will remain a compelling incentive to securitize. Securitization still remains competitive in the face of other forms of term funding and is likely to support deal flow over 2008, they added.
Europe's SME market is largely divided into four subsectors led by the more traditional German and Spanish SME CLOs and by the German profit participation agreement (PPA) CDOs. Smaller SME CLO categories from other areas are also part of the mix. Credit performance in the traditional SME CLO sector remained generally robust, but for hybrid deals, the setbacks that kicked off 2007 continued straight through the year.
The Erich Rohde KG default earlier in the year affected three deals - Capital Efficiency Group's PREPS 2004-2 and 2005-2 as well as Commerzbank's MezzCap. Even as late as November, the MezzCap deal was still rocked by negative headlines. Standard & Poor's placed the transaction's class B, C, D and E notes on CreditWatch with negative implications following the filing for insolvency of Optical Disk Services. "The defaults highlight the potential scope for adverse loan selection in this sector and the risks of obligor overlap in securitized portfolios," Deutsche Bank analysts said. "We see further material risks to the mezzanine SME CLO sector in Germany, stemming from credit impairments as well as the likely challenges to capital market financing for, and therefore the very viability of, existing lending."
Synthetic Transparency Surprising
Nevertheless, sources say that there are encouraging signs that might spell recovery for certain structures.
Synthetic structures have been quite resilient in the face of the liquidity crunch. The product's transparency has offset its complexity. European synthetic CDOs have their value derived from more simple instruments, and knowing the value makes it easier to determine the values for synthetic CDO tranches. Royal Bank of Scotland analysts said that the synthetic structure's customizable risk profile, its transparency, its cost-efficient trading, its superior liquidity against cash CDOs and its lack of warehousing/ramp-up risk are expected to make it an ideal investment for 2008. "Synthetic CDO products should enjoy a constructive 2008 having proven themselves against opaque and illiquid cash CDOs during the credit crunch," analysts said.
A new development for the European CDO market this year will be the consolidation of synthetic technology across all major asset classes, Merrill Lynch analysts said. Synthetic CDOs of ABS should still offer value in 2008 and could contain the features available for corporate deals, including short buckets and principal-protected equity.
The market should also expect the debut of single-tranche synthetic CLOs. "With the development of synthetic ABS tranches, single-tranche CLO is now the missing link in the picture, and should develop rapidly in 2008, now that LCDS indices are up and running in the U.S. and Europe and standardized tranches have already started trading in the U.S.," Merrill Lynch analysts said.
How fast this product will gain ground remains a question mark. For one thing, it's uncertain whether synthetic products will complement or compete with cash CLOs given that cash collateral and loan issuance are expected to decline further. Market players can also expect a smaller market, with first-half 2008 issuance led by 2007 vintage loans at post-crisis spreads. Royal Bank of Scotland analysts said it won't be until the second half of 2008 before new vintage loan CLOs can begin to filter through.
Although loan default rates are expected to rise over the next 12 to 18 months, CLO tranches should withstand the difficult market conditions ahead. A rise in defaults will lead to a tighter loan market but buyers can at least look forward to less systemic loan default risks. Analysts at Deutsche Bank noted that the diversity of both industry and geography for European loans better protected European CLOs from blanket defaults across European structures. But with no new transactions slated in the first quarter of 2008, a more prominent threat to the market could include a dramatic fall off in loan market volumes which would eventually impact portfolio replenishments in European deals. "The sustainability of volumes in the longer-term will of course depend on whether CLO platforms remain economically viable in the down-sized, post-crisis loan mark," explained the Deutsche analysts.
Although 2007 was supposed to be a good year for European commercial real estate CDOs, volumes failed to measure up. Last year proved to be an altogether disappointing year for this relatively new structure - only two deals came to market in 2007, for a total issuance of 1.3 billion.
The low issuance, despite buy-side interest at the end of 2006, justifies the doubts critics have raised about the lack of available collateral. "But it is not only supply," Merrill Lynch analysts said. "With the European CRE market outlook being moderately to heavily cautious for 2008, it remains to be seen whether the exposure to this type of collateral will be in high demand in a recovering CDO market, where investors are more likely to seek security and stability."
Market participants say that the European CDO market overall will need to see liquidity returning before it makes a full recovery. With European CLOs - one of the larger segments of European CDOs - potentially more vulnerable to further performance pressures on the back of an expected increase in corporate defaults this year, investor confidence is expected to further dwindle. Observers believe that the market needs to see better differentiation between products to reduce the vulnerability of CDOs to specific credit problems.
"A retrenchment in liabilities costs would reignite the CLO arbitrage, motivate further innovation and boost balance-sheet securitization as European banks find their cheap funding tool back," Merrill Lynch analysts said. "Our base case scenario for next year is somewhat in the middle, with continued softening of credit fundamentals, a slow tightening of CDO spreads across the boards (although nowhere close to 1H07 levels), and issuance 10% to 20% down from this year's total, around 70 billion to 80 billion."
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