The newest developments and dramatic growth within the single-name home equity ABS credit default swap market lies behind some of the biggest innovations within the structured finance CDO sector seen this year. These developments not only are responsible for some of the volatility seen of late, but also a new world of innovation. The ABS CDO market - often deemed the "CDO machine" by market participants, has been a huge patron of home equity ABS this year, with collateral portions in more than a few deals topping 80%.

And as search for yield has left desirably priced ABS collateral scarce in order to complete CDOs, the ability for portfolio managers to mix synthetic collateral with cash collateral is allowing CDOs not only increased diversification but the ability to ramp up a deal in a much faster time frame. "While accumulating $250 million in triple-B rated cash [home equity] securities could take as much as three-to-four months, the CDS market allows an equivalent sized exposure to be taken on in the course of a single day," according to Bear Stearns.

Liquidity, concentrations increase

The home equity ABS default swap market has made great strides in liquidity this year, along with the CDS of CMBS, and as these asset classes mature, others are expected to follow.

Synthetic issuance within the home equity sector is expected to reach well beyond $100 billion this year, according to Nomura Securities, from what Bear Stearns called only a "negligible" amount in 2003. And while the synthetic ABS market is only a small portion of the projected $20 trillion global credit derivatives market, it is expected by many to be the next big growth area within the sector - having the two-pronged affect of continuing to propel the ABS CDO sector, while at the same time drawing increased scrutiny.

"In the past two years, [home equity] ABS has acquired global sponsorship, propelled ABS issuance to the $1 trillion mark, and virtually given rise to the [home equity] CDS and real estate CDO markets," according to RBS Greenwich Capital analyst Peter DiMartino. And the [home equity] ABS performance will dictate, in large part, the direction that much of the real estate CDO market also turns. "As the [home equity] ABS market goes, so too will the rest of the ABS, HEL CDS, and RE CDO markets go," DiMartino continued.

Nomura agrees, writing, "the implications of the higher concentrations - 75% to 90% of residential mortgage assets in SF CDOs is unclear. Should the U.S. residential mortgage market sector start to come under stress, popularity of "real estate play" CDOs can quickly evaporate." Nomura is anticipating U.S. CDO issuance to hit $150 billion in 2005 and remain brisk in 2006, with projected issuance at some $60 billion through the second quarter. "However," Nomura notes, "uncertainty looms on the horizon, particularly with rising interest rates and cooling housing markets, as well as possible stress in the high yield corporate sector."


A deluge of activity followed the International Swaps & Derivatives Association's development of the pay-as-you-go format for cash settlement of ABS CDS in June. As hedge funds and others looked to gain short exposure to the subprime mortgage market, volatility returned to the cashflow home equity ABS market. Hedge funds are estimated by Fitch Ratings to control some 25% to 30% of the CDS market. The basis between the cost of buying protection on triple-B rated home-equity ABS and where those cash securities were trading, ballooned to as much as 125 basis points in mid-November.

"The rapid convergence of cash and synthetic instruments may have caught even CDO professionals unprepared. The cash and synthetic markets continued to use divergent analytical approaches, as if they hold totally different views of the world," Nomura wrote. And that dichotomy is anticipated to perpetuate differences in pricing - from timing to perceived value. But the price discrepancy has all but spurred continued innovation in the CDO market.

New Structures

Some of the most talked about structures to come to the market this year include a host of transactions under the umbrella of the "hybrid" CDO, which incorporates both synthetic and cash assets. One structure, which picked up steam following formal documentation release in June was a type of CDO, such as State Street Global Advisors' Pascal CDO Ltd., that includes both cash and synthetics on the asset and liability sides of the capital structure.

What most defines the hybrid CDO structure, according to Nomura, is the unfunded super-senior revolver, which is sized approximately to the notional of the synthetic exposure. Credit events within the reference portfolio are covered by drawing down the revolver. Revolver investors generally are compensated based on how much of the revolver has been drawn.

Other notable structures include the leveraged super-senior and the changing face of the commercial real estate CDO space.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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