Wall Street dealers, some of which are rumored to be taking substantial losses from the ailing subprime mortgage market, are tightening the purse strings - in part to limit their exposure to mezzanine ABS CDOs. Rumors were running rampant last week of pulled or significantly tightened warehouse lines, liquidations and difficulty selling deals once they had priced.
"Across the Street, dealers have been taking more risk. It's been a larger book of business for them, but now they've got too much exposure long the risk," said one CDO asset manager. Dealers last week were looking to buy short positions on the ABX indices in order to hedge what in some cases was an overwhelmingly long bet, sources said. "That's what the meltdown is all about. Everybody is long, and the warehouses don't want to fund it," said another CDO manager.
Merrill Lynch, coincidentally the largest unsecured creditor behind bankrupt subprime lenders Mortgage Lenders Network USA and Ownit Mortgage Solutions and allegedly the impetus behind ResMae Mortgage Corp.'s decline, was rumored last week to be the leader in the "credit pull." Bear Stearns and UBS were also named among those looking to shed exposure to subprime.
Rumors circulated about ABX losses - ranging from $300 million to $1 billion - at Goldman Sachs, Bear Stearns and Merrill, although none were confirmed as of press time. Morgan Stanley circulated a multi-million dollar warehouse CDO liquidation bid list Thursday morning comprising subprime, Alt-A, CDO and CMBS securities.
While some deals were successfully priced and at least one CDO asset manager claimed to be close to securing an additional warehouse line, the overwhelming sentiment was of a standstill in liquidity from the Street, until dealers could hedge their exposure. Certain dealers offered funding only for assets sourced in-house, several sources said.
The ABX continued its volatile swings last week, as dealers looked to the index to hedge exposure, and hedge funds continued to place negative bets on the subprime lending market. The ABX index was on its way to a recovery Thursday afternoon, but on Wednesday had closed at 66.23 and 70.50 for the triple-B-minus index of the 06-2 and 07-1 series, respectively. The TABX, itself erratic, played its part to heighten concern over mezzanine ABS CDOs. "There is a lot of fear," said Armand Pastine, a managing director at Maxim Group. "You can sense that there is a lot of trepidation right now with managers, Wall Street underwriters and with warehouses. People are a little spooked by what they've seen with the prices on subordinate RMBS."
The loss of CDOs as buyers of subprime securities would exacerbate challenging conditions in the subprime mortgage market. Subprime lenders, struggling amid poor loan performance in recent vintages and subsequent loan buyback requests, need as much liquidity as they can to keep running. CDO purchasing of subprime securities has, up until recently, been counted on as a stabilizing force in HEL spreads.
Market participants last week largely cited a falloff in more marginal CDO managers - an event that has been expected for some time - and a declining number of CDOs backed by cash and mezzanine subprime collateral as outcomes to the changing investor appetite. Most likely those managers that will struggle, they said, are relatively new CDO asset managers with less of a reputation and fewer relationships. Louis Lucido, group managing director of Trust Company of the West's credit mortgage group, said last week's events did not come as a surprise. "It will squeeze out weaker issuers and managers," Lucido said.
Maxim Group's Pastine said he wouldn't be surprised to see some firms grow their business in the current environment. "Some people have certainly shut down warehouses and liquidated deals, but the rest aren't going to go away," Pastine said. "This will be the market that people's characters will be measured by."
As for the shape that deals coming to the market will take, market participants point to the convergence of synthetic and cash CDO desks on Wall Street as one of the reasons why synthetic issuance is poised for growth. Sources said dealers have an easier time hedging risk for synthetic deals than for cash securities. Interest also turned to high-grade deals, as investors and managers sought higher credit ground. As well, protection buying higher in the capital structure is cheaper - at least for now.
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