BARCELONA - For every good party, there are swarms of uninvited just waiting to crash it. And as one participant at Information Management Network's ninth annual Global ABS Conference' held here said last week, "the party has been crashed."
By day attendees complained about headaches and tight spreads and tapped-out liquidity, suggesting that as issuance in the asset-backed securities market has outpaced the size of the corporate bond market for the first time, the ABS market is not - and may not be again - what it once was.
That doesn't mean that attendees didn't mingle till dawn at the beachside clubs, snatching up Cava and caviar throughout the conference's exhibit hall, where one vendor's hangover cure kit was arguably the hottest giveaway.
"I'd certainly like it if spreads widened a bit. That's for sure," said Richard Paddle, head of credit trading at HBOS Treasury Services Plc. "But this is no longer an emerging market, and while continued growth will always be there, the commoditization is the reason this market will continue to tighten." Paddle said strong asset performance and spread-to-risk ratios that are wide compared with corporate bonds prove that spreads still have space to squeeze inward.
Strong demand - whether the blame lies with the CDO bid, European investors, or real money accounts - has allowed issuers to drive spreads down to levels some believe are unsustainable.
In comparing European covered bond market pricing to standard residential MBS, Iain Barbour, global head of securitization at Commerzbank Securities said "it doesn't take a rocket scientist to determine that you are getting more return for less risk in MBS - that is why there will be spread tightening." And across the board, supply and demand will dictate more of the same, some say. "This is where it is going to be trading for the next two-to-three years," said Laila Kollmorgen, in the credit-flow trading group at BNP Paribas.
To be sure, a rise in the number and frequency of investors seeking exposure to ABS has resulted in a broadening array of securitized assets and structural innovation. Thirst for ABS exposure, albeit short exposure, is evidenced by growth in the established European synthetic market, along with the relatively new, fast growing market for synthetics in the U.S. Investors are looking high and low - to super senior tranches to equity tranches - in search of spread. And there is a hunt on for new esoteric assets and untapped markets.
"In Western Europe, we are just sitting on a pile of assets, and institutions are just not parting with them," pointed out Kurt Sampson, a managing director at Standard & Poor's.
There remains a fare share of optimists, however, as some believe that a combination of irresponsible pricing, a few blow-ups caused by deteriorating credit quality - particularly in recent-vintage home equity ABS - and future innovative structures will return the market to at least some semblance of its glory days.
John Devaney, president and head trader at United Capital Markets, Inc., is bullish on that sentiment.
Devaney, who did not let Barcelona's six-hour time difference from the East Coast keep him from trading some distressed ABS, is adamant that spreads on certain subordinated bonds are already widening, and for the rest of the market, it is just a matter of time before a correction occurs.
The same market phenomenon that has yields on 10-year Treasurys flirting with sub-4% yields, despite a series of interest rate hikes by the Federal Open Market Committee, stem from the same technical forces driving fixed-income spreads tighter over the last 18-months, Devaney said. "All of the spread tightening is an enormous carry game being played right now by hedge funds and CDOs," Devaney said.
He added that he hasn't purchased any new-issue ABS in two years because he doesn't think the risk and reward ratio is worth it. Instead, UCM is focused on purchasing and repackaging distressed assets, which he likens to "being a loan shark at a pawn shop." UCM is set to issue its second deal this year consisting of repackaged aircraft lease securities.
Andrew Burgess, head of ABS at Gulf International Bank Ltd., said he is seeing the early stages of spread widening in the U.K., adding that inexperienced investors are not paying attention to a so-called low premium on risk, and that too few are assuming that there is going to be widening in the market. Instead, anticipating tighter spreads, some, such as certain CDO managers, are ramping up deals that are unlikely to make it through a blow up, he said.
"They forget spreads can widen," said UCM's Devaney, "I am hearing in conversations, this deal will be okay, because spreads will tighten.'"
Most of the ABS issued lately is backed by residential mortgages, most being adjustable rate. Particularly for subprime borrowers, if the federal funds rate continues rising, refinancing out of loans that have reset upward could be rather difficult, some point out. More than a handful of recent new-issue CDOs have either been backed by a majority of, or completely by, subprime and prime mortgages.
MBIA rejected placing insurance on 90% of 80 to 100 CDO deals the insurer looked at last year, said Christopher Weeks, a managing director at the guarantor. The rejected deals were primarily exposed to ABS, he said, and run by managers with little experience in the field. "In the CDO market, I would sound a note of caution," Weeks said.
And while Devaney and other like-minded traders wait for a blow-up to occur, others are at least saying that the spread differential between senior and subordinated bonds, for example, is irrational and bound to correct itself. The scenario is worse in Europe than in the U.S., according to Weeks and Burgess, who said it is easier to ramp up a deal in the U.S.
"We've seen European ABS pretty much drying up," said Dagmar Kershaw, head of CDOs at Prudential M&G. "The underlying assets are becoming more risky, and [inexperienced managers are forced to buy bad collateral and] cross their fingers that everything will be okay."
Dino DiCosta, a vice president at Credit Suisse First Boston, said he expects spread differentiation to pick up, along with delinquencies in mortgage-backed CDOs, and Robina Barker Bennett, a managing director at CIBC World Markets, said that one place managers of structured finance CDOs can look for spread differentiation, even in Europe, is in esoteric assets. Tiering between asset classes, she said, instead of tiering within a single class, is key.
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