NEW YORK-Widespread talk of a meltdown in the U.S. housing market - and the effects it might have on the structured finance market through the RMBS sector - have not diminished the popularity of carry trades in the cash CDO market. Indeed, the power play continues to attract a lot of hedge fund and similar fast-money players, said several analysts at the Bond Market Association's (BMA) CDO Investors Conference held here last week.
"It's been remarkable to me how well the carry trade has continued to perform in the face of an obvious backup in rates," said Arvind Rajan, a managing director at Citigroup Global Markets. Carry trades, particularly those that involve going short on particular parts of the transaction and retaining the cost of the carry, makes a lot of sense for the ABS market, and the CDO structure is the best way to pull it off, panelists at the conference said.
The BMA estimates the outstanding amount for the cash flow CDO and synthetic funded markets to be $153 billion and $21.8 billion, respectively. Any cash flow CDO sector that can go synthetic has suddenly become attractive to hedge fund and other investors, which increasingly attach more importance to technicals over fundamentals, said Lang Gibson, director of U.S. CDO research at Merrill Lynch. In the ABS market, hedge fund and similar operations are taking up long-dated equity positions on tranches of ABS CDOs, and they are shorting their positions in a variety of ways - including triple-B rated debt. In January, investors that pulled off the trade were able to reap arbitrage levels at around 25%. Although the arbitrage has decreased significantly, to about 4.5%, market players are still drawn to the carry trade because of the absence of OCIC tests.
"This has historically been a significant concession to equity holders," Gibson said. "That should bring in more real money investors."
As for other portions of cash flow CDO deals, Gibson said that triple-B investors already receive a lot of concessions for taking up their riskier positions. However, investors at the top of the capital structure have seen some value drawn out.
"This is kind of the big thing that we see happening in any cash flow market that goes synthetic," said Gibson. "We expect to see that in CLOs down the road."
Indeed, CLO investors are beginning to make ballpark estimates on where the delta of a triple-B CLO is, as they try to hedge for certain positions on those deals. Although that approach does not begin to match the level of sophistication used in the synthetic CDO market, it will happen on an increasing number of CLO deals in 2007, said Claude Leberge, a vice president at Lehman Brothers, who leads the cash CDO research and strategy group for U.S. and Europe.
Necessary changes
Although there is value in CLOs, relative to the equity high-yield markets, investors need to see a couple of changes in the market before they do CLO carry trades in earnest next year. First, there is a chance that investors might get squeezed between widening spreads on double-B or triple-B tranches and spread compression on the high yield markets, Rajan said. Each trade would have to attract a critical mass of investors in order to make the technicals work in anyone's favor.
Furthermore, the opaque, illiquid and one-sided aspects of the CDO market call for universal risk standards, which especially address how fundamental changes in the residential market are likely to impact the out-of-money options that some market players put together in buying tranches of ABS CDOs, Rajan said.
Although CDO market transparency has improved dramatically over the last several years, Rajan said that evaluating the written option value on ABS CDOs is very difficult. The market's current liquidity will eventually deteriorate substantially and even the lack of liquidity is out of the money at the moment.
Not all panelists agreed that more transparency is needed in the CDO market. The asset class is about as transparent as it can get at this point, Leberge said. Some managers and investors know CDO deals by heart, and can get essential information about the deal from the tranche level.
For its part, the BMA did its share to provide a bit more efficiency in the CDO market. It introduced a standardized format for versions of the monthly electronic trustee reports generated in CDO transactions. The new format allows users to import, process and manipulate data files - in a machine-readable format - from any participating trustee (see Whispers).
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