Performance of both high-grade and mezzanine CDOs should remain on par with one another, as long as the national U.S. rate of home price appreciation remains at a long-term average of 5%, according to Lehman Brothers. Analysts at the investment bank wrote last week that a more challenging scenario for the consumer - such as a flat or negative rate of home price appreciation - would find the high-grade transaction significantly less affected than its mezzanine counterpart.
Collateral used in mezzanine CDOs is overall more leveraged than a high-grade deal to a downturn in the housing market - meaning defaults would likely increase rapidly if the housing market were to deteriorate drastically, Lehman wrote. And while required levels of credit enhancement would cushion the mezzanine deals against defaults in a moderate or slightly down home price appreciation environment, an extreme downturn in the housing market would leave the deals with more than a 40% cumulative loss. Lehman calculated cumulative losses for the "average" high grade and mezzanine CDOs based on the average home equity loan sector and rating concentration within these two types of CDOs.
In terms of average, 2005 vintage high grade and mezzanine CDOs, a 5% or higher rate of home price appreciation would result in cumulative losses greater than 0.3% and 1.0%, respectively. In a so-called "pessimistic" scenario, where home price appreciation is 0% for three years and 5% after, losses increased to 7.5% for the mezzanine deals but only to 0.7% for the high-grade deals, Lehman found. In a "meltdown" scenario, or a negative 5% rate of home price appreciation for three years and 5% home price growth after, mezzanine CDOs would experience 46% cumulative losses, while the high-grade transactions would experience 5% cumulative losses.
Mezzanine transactions typically have an additional 10% to 15% level of credit enhancement at the triple-A level and 4% to 5% at the triple-B level.
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