Using a sample of 14 mezzanine structured finance CDOs issued between the second half of last year and the first quarter of this year, Merrill Lynch found the investment vehicles generally carried lower risk residential mortgage collateral when benchmarked against the home equity ABS sector.
"We were pleasantly surprised that the CDO managers were buying less of the risk that the media has given a lot of attention to recently. Basically on all counts they had less risk in the market, and we think that is important because investors at the CDO level don't necessarily understand how the agencies size credit enhancement for this extra risk," said Lang Gibson, head of CDO research at Merrill. "It requires a lot of trust on behalf of the investor."
The study compared such factors as concentrations of interest-only loans, non-owner occupied properties, option ARMs and second-lien loans, as well as loans originated in suspect boom areas. Merrill analysts determined that, in general, the CDO managers selected collateral with fewer of these loan types than the portion that exists in the overall home equity sector.
The analysts stated in the Aug. 1 report that credit support required by rating agencies for particular mortgage products thought to be more risky, coupled with the manager's ability to pick and choose mortgage collateral, supports the notion that risk can be alleviated. Merrill said investors should use the same benchmarks used in this study to examine various deals and tranches for what could be extra value veiled by an inflated perception of collateral risk.
"Quite a lot of work is involved to simply calculate property and affordability exposures in the underlying loans of [Structured Finance] CBOs based on public information," Merrill researchers stated. "Uncovering the obstacles to obtaining this data reminded us why there is a significant complexity-related spread pick-up in [Structured Finance] CBOs."
But some say that spread pick-up should be risk-related, and it should be larger. CDOs highly exposed to subordinate ABS bonds have drawn criticism from more than a few in the investment community. PIMCO, for example, voiced its decision earlier this year to quit managing CDOs for the time being - primarily because of what some say is a low cash cushion issuers are offering investors on the products to compensate for risk. And JPMorgan Securities last week restated its earlier underweight opinion for structured finance CDOs. JPMorgan analysts have voiced concern over the housing market and current interest rate environment. Mezzanine structured finance CDOs have an average 70% to 85% allocation of home equity ABS, according to Merrill.
"We've been more bullish in terms of how junior-rated CDOs go," Gibson said. "Over the entire year, we've written about how we're bullish on ABS CDO tranches versus other CDO sectors due to a large spread pick-up on absolute and empirical loss-adjusted basis, advantageous synthetic supply technicals, and their relatively shorter average lives."
Gibson cited the 270 basis point over Libor yield on a triple-B ABS CDO versus only 170 basis points over Libor on a high yield CLO in the current market as a significant advantage for investors. The 100 basis point pick-up compares with an average 76 basis point pick-up last year and 55 in 2003, he said.
Merrill found the CDOs it analyzed had average exposures of 2.5% for second home properties; 7.9% for investor properties; 19% for IO loans; 2.1% for option ARMs; and 2.2% for second liens.
Versus the average of the 2004 to 2005 subprime and Alt-A market benchmarks used by Merrill, second homes and second lien mortgages had, on average, roughly the same exposure in the 14 CDOs. The average CDO's 19% IO exposure compared to 13.2% exposure found in the subprime benchmark, and 42.5% in the Alt-A benchmark. Similarly, investor properties figured into 7.9% of the CDO pools versus 5.7% in subprime and 17% in Alt-A. In all of these categories, other than option ARMs, Merrill excluded one outlier CDO which would have upwardly skewed the results.
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