As if the structured finance CDO market has not been dragged through the mud already, market-value CDOs appear to be the latest investment vehicle wounded by the lack of liquidity in the mortgage sector.
With forced liquidations driving several funds to unload their assets, similar funds may follow suit as their values decline even further, market participants predicted last week.
"The risk in this environment of low liquidity is that asset sales from one transaction liquidation reduces prices on other market-value deals, which leads to further liquidations," Lehman Brothers analysts said in a report.
Indeed, TCW Asset Management liquidated $3.2 billion in both agency and triple-A private label MBS collateral backing MV CDO Westways Funding X. Interestingly, a black cloud appears to be hanging over the Westways name. The deal is supposedly named after former TCW managing director Fred Horton's Maine farm, which is located near the site of Stephen King's infamous car accident.
Westways's misfortunes do not end here. Five other similarly structured transactions, including Westways VI through Westways IX and Westways XI, have all been downgraded by Fitch Ratings. In many of the deals, classes of notes dropped at least one full rating category. Triple-A notes were placed on rating watch negative.
Moody's Investors Service has also downgraded notes in the same funds, which continue to be on review for further downgrade.
Moreover, sources said that with spreads widening significantly, there is some potential for the other Westways deals to be liquidated, following in the footsteps of Westways X.
Though Babson Capital Man-
agement's $200 million Enhanced Mortgage-Backed Securities (EMBS) V MV CDO recently finished liquidating - the fund was backed by mortgage and asset-backed bonds and had an average rating of AA' - another Babson fund, EMBS IV, was downgraded by Fitch.
Fitch has also rated two other similar Babson funds in the EMBS series that are currently performing in line with expectations, said John Schiavetta, managing director at Derivative Fitch. Babson declined to comment on the specific funds or the current state of the MV CDO market.
While the credit quality of the collateral backing an MV CDO deal certainly plays into pricing, factors other than credit deterioration are causing widening spreads, at least in the case of the Westways deals, said Yvonne Fu, managing director in the structured finance group at Moody's. Fu cited negative sentiments in the market about mortgage-backed securities.
Further, many of these transactions are backed by higher quality collateral. To be sure, 60% of the assets in the Westways transactions are agency Triple-A, with the remaining concentrated in nonagency prime Triple-A, Lehman analysts said, noting that the total outstanding MV structured-finance CDO market is about $10 billion to $20 billion, $11 billion of which is from the Westways program. While a couple of other issuers have MV CDOs outstanding that use subprime collateral, the market value of those deals is less than $5 billion, Lehman said.
Given these factors, breaches in performance triggers may have resulted from a variety of factors, according to analysts, including a higher degree of volatility for assets in one CDO compared with collateral in other MV CDO deals. Structures could also hit their triggers because of a prior decline in market value before this most recent stress, reducing the trigger cushion. But investor hesitation in the mortgage sector seems to be the root cause of the recent liquidations, in particular Westways X, market participants agreed.
"There are absolutely no credit concerns with regards to the collateral in the portfolio [of Westways X]," Schiavetta said. "It was all spread widening and resulting price movements on the bonds."
Indeed, investor jitters have halted cash flows into the MBS market, causing spreads to gap out. With the lack of liquidity and volume, marking assets has been difficult, said Brian Yelvington, macro strategist at independent credit research firm CreditSights. He also noted that along with the increase in volatility, a lack of transparency in the market has halted manager activity, and in some cases, forced an unwind.
These market-value structured programs, across all asset classes, are designed to relever and delever according to turbulence, unwinding in periods of volatility to avoid further loss, Yelvington said. "But here we have had a double whammy of turbulence. It is one thing for spreads to move wider, and it is quite another to have lack of liquidity and an opaque market in your face at the same time."
Others agreed that the lack of liquidity has made MBS asset-valuing difficult. "In certain assets, such as high yield bonds, everyone knows what the value of the asset is, but assets that are less liquid [like MBS], that is where the funny things could happen," a CDO market participant said.
Corporate Names Not Immune
However, MV CDOs that reference corporate names are not immune to widening spreads. These structures are equally present in the MV CDO market, according to Fitch's Schiavetta. But he pointed out that spread widening in corporate structures has for the most part been absorbed.
"There have been modest stresses, and we have had downgrades, but certainly nothing like we have seen in the mortgage space," Schiavetta said, adding that there have been no liquidations in the Fitch-rated corporate MV CDO sector.
Moody's had not yet taken rating actions on corporate MV CDOs, Fu said. While asset value has declined in recent months, she noted, Moody's has not been overly concerned about ratings on the [rated] notes, but it continues to monitor these ratings closely. Despite the lack of immediate concern, liquidity keeps disappearing in the credit markets, which could push spreads farther out. "Clearly, everything associated with any of these markets right now has a taint to it," said a CDO manager.
Manager viability will also weigh on CDO structures as these firms continue to face margin pressure and heightened investor discrimination. If the new-issue CDO market continues to decline, impairment rates for existing ABS-focused CDO managers could be as high as 40%, with the number of managers across all CDO sectors contracting as much as 20%, Derivative Fitch said in a report last week on CDO asset manager impairment. The rating agency added that market-value CDOs that rely on the manager's active trading and market acumen will suffer the most if the manager is struggling.
Rating instability has also fueled concern regarding potential liquidations in the MV CDO sector. Market participants pointed out that rating agency models, which incorporate spread price movements into their assumptions, may have rosier expectations for spread levels, considering the lack of historical data.
"The events we have had over the past few months are unprecedented in terms of market price volatility," the CDO manager said. "Apparently events went beyond the stresses that are tested for."
At the same time, tight value constraints on the deal also add to ratings vulnerability. "When you are working with the sometimes razor-thin margins and stops contained in some structured products, it does not take much to get quite a great deal of ratings volatility," CreditSights' Yelvington said. "And if you expand what we have seen in subprime to what might happen when corporate defaults run above trend, we are likely to see the same huge gut reaction in the corporate markets. I don't think that we have seen the end of this ratings arbitrage headache."
Semblance of an SIV
Exacerbating concerns about MV CDOs have been the correlations drawn between its structure and that of SIV lites, another market-value vehicle facing potential asset sales. "Really, a SIV lite is an ABCP product that has a capital structure on it and participates in a lot of different asset classes. You can definitely draw a parallel there with MV CDOs," Yelvington said. He added that both vehicles have a lot of flexibility in what they can invest in and have similar structures, including tranching. The only major differences Yelvington pointed out are that the SIV lites will constantly issue paper, whereas market-value CDOs are deal-based. "SIVs are like an ongoing business: As long as the entity maintains certain levels of capitalization and invests in certain assets, it is constantly able to issue in order to fund assets, ratingswise," he said. "A market-value CDO is designed to have a finite life and fund in accordance with the expected life of the deal." The other main distinction between the two vehicles is funding, market participants agreed, noting that SIV lites fund themselves in the ABCP market, whereas mortgage MV CDOs, such as the Westways structure, fund in the repo market.
However, each of these vehicles has market-value triggers that do not work very well in the current market environment, where price is determined by liquidity rather than by credit, Alex Rekeda, head of U.S. structured finance at Mizuho Securities, said on a conference call last Tuesday. "Both products are pretty risky from the perspective of being able to survive in this market," he said, "and if we see some MV CDOs collapse, then we may see some SIV lites collapse as well."
Further, unloading paper in an illiquid market can be difficult. "The problem is, in principle, you can sell anything you want - the manager has a great deal of latitude. But in this particular market, the only thing you can sell is the good stuff, and you are stuck with the assets that have a terrible value," the CDO market participant said.
Yet despite their reluctance to buy MBS paper, market participants expected that these structures would eventually sell off the assets. In the case of Westways, the high-grade collateral represents value, which seems to mimic the higher-quality portfolios characteristic of other mortgage MV CDOs, they noted.
In a market dislocation, the manager or a trustee - to protect the interest of the noteholders - usually has some discretion in choosing a good time to go into the market and sell assets, market participants said. Depending on the defeasance program, a manager may choose to wind down the portfolio more slowly, assign creditors different buckets of assets or pay down senior creditors first as opposed to a massive liquidation. "At some point, there is a bid for virtually every piece of collateral," Fitch's Schiavetta said.
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