When it comes to New Year's resolutions, Standard & Poor's commissioned a mighty goal for itself. The rating agency announced it is in the process of rolling out a benchmark for ABS CDOs, a collateral class exploding in terms of issuance volume.
In the world of securitization, few other instruments have seen the level of disagreement over performance and, subsequently, pricing in the secondary market as the ABS CDO sector. While a benchmark won't solve every debate, it would provide a much larger window through which to view a sector rapidly growing in market dominance.
"The goal here is to compare the rating performance of the ABS CDO to the ABS market," said John O'Brien, primary credit analyst at S&P. "What we're trying to get at is to highlight the manager's security selection ability."
The announcement of the soon-to-be created benchmark was made during a conference call last week that focused on the performance of ABS CDOs. It was pointed out that the majority of ABS CDO transactions that experienced a negative ratings action also underperformed their ratings benchmark on a collateral rating basis. And CDOs with large amounts of real estate collateral performed well from a ratings standpoint.
The proposed benchmark will not consist of weighing a CDO's collateral directly against the ABS market. "A market weighted benchmark will not give an accurate indication of collateral rating performance overall, because CDOs invest in different assets than the market," O'Brien explained.
Early stage testing by S&P analysts showed that sample ABS CDO portfolios, when compared directly to the ABS market, were more highly weighted in certain assets than the ABS market's issuance by ratings. For example, one sample ABS CDO portfolio from an early vintage showed that 9% of its collateral derived from manufactured housing when comparatively, 2% of issuance in the ABS market by rating was backed by manufactured housing. Analysts concluded a side-by-side comparison would not be effective.
"Instead, we're proposing to create an ABS benchmark using the sector and ratings base of the assets in each CDO," said O'Brien. "We're going to calculate the overall rating change of this benchmark and compare that change to the rating change of the collateral in the CDO."
Since collateral composition of ABS CDOs has varied widely since the sector's inception in 1999, it does create some challenges for the proposed benchmark.
"A further enhancement to this methodology would be to segment this database by the year of collateral issue," added O'Brien. "There are some limitations. We did not consider collateral substitutions during the period of trading, which grows the portfolio composition and transaction economics do play a factor, although probably less of one than you think," he noted.
At the moment, the benchmark is classified as "proposed," as S&P continues broader sampling. It would be available to S&P clients once the benchmark's methodology is refined.
As S&P took a closer look at ABS CDOs, its had enough historical data to establish some new research findings about this sector, one of which confirmed that the majority of vintages from 2000 to 2002 did buy different collateral than the overall ABS market. Sectors such as manufactured housing and commercial ABS were overweighted in these vintages compared to the market index. Vintages issued after 2003 contained more real estate-focused collateral, such as RMBS and CMBS.
"What I find interesting is the actual performance of earlier vintages of CDOs of ABS. The predominant amount of this activity in terms of ratings downgrades are attributable to the fact most of these deals were focused on multi-sector diversified pools," said S&P Managing Director David Tescher, of the 2000 to 2002 vintages.
S&P's historical figures also revealed an interesting point - despite poor performance of older ABS CDO vintages, issuance volume has skyrocketed. S&P saw a 76% increase in rated dollar volume between 2003 and 2004 - $26.72 billion to $47 billion - and saw a 71% jump in rated transaction volume during that period.
Of course, ABS CDOs issued in 2003 and 2004 changed dramatically, explaining the growth in popularity in the last two years.
"The composition of these transactions had multiple asset sectors in addition to migrating to more of the pure-play real-estate concentrated ABS pools," said Tescher of the 2003 and 2004 vintages. So, while older vintages suffered downgrades, Tescher predicted that in the near term, thanks in part to prepayment speed, some of the more static CMBS transaction that have de-levered would start to garner upgrades.
However, so much focus on real estate asset backed securities has raised concerns over rising interest rates and overexposure to consumers, Tescher noted a migration for more relative value. "We're starting to see some CDOs of ABS actually migrate back to include some of the sectors that were in the earlier vintage deals," he said, "Some senior tranches [are comprised of] manufactured housing, franchise and EETC collateral."
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