Despite significant collateral and structural differences, some market participants are expecting TABX and mezzanine structured finance CDO spreads to converge. This is an unsettling thought to CDO issuers - but a possible scenario to real estate bears.
While TABX spreads have been blamed for at least a portion of widening experienced in CDO liabilities over recent weeks, so far, TABX spreads have remained comparably wider.
JPMorgan Securities analysts, who believe the real estate adjustment is in its early stages, wrote last week that they do not think differences in liquidity, structure and diversity fully explain the remaining basis between TABX and CDO liability spreads. "Significantly worse collateral composition justifies a large portion of the current basis," JPMorgan analysts wrote. "However, the gap appears too wide and we expect convergence."
For those also expecting convergence, the analysts are recommending going long TABX from 10% to 40% and going short on double-A to triple-B single-name CDO credit default swaps. For an ABX widening trade, one could short the 40% to 100% TABX triple-B minus - especially in light of recent short-covering, analysts suggested. For an ABX tightening trade, they recommended going long on the 15% to 25%, and they called the 10% to 25% range the TABX sweet spot.
The analysts also said that mezzanine structured finance debt spreads need to increase at least 33% to 50% before they are consistent with current market implied losses for both the ABX and TABX indices - and the analysts' own home equity loan loss projections. The average 2006 mezzanine structured finance CDO could widen by roughly 25 to 50 basis points for double-A, 300 to 400 basis points for single-A, 400 to 600 basis points for triple-B and 200 to 300 basis points for double-B, analysts wrote. Based on current pricing, those predictions would result in absolute levels ranging from 100 to 125 basis points for double-A to 1,100 to 1,200 basis points for double-B for average 2006 deals.
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