Ironing out language-related wrinkles in credit default swap deal documentation along with last month's launch of a new U.S. ABS index means an obscure area of the CDO market may be ready for substantial growth.
Volume is growing rapidly in a specific type of CDO that synthetically references asset-backed securities. Some believe it could surpass the issuance volume of cash-backed CDO deals in 2006. The cash-backed structure is by far the market's most popular security.
"We anticipate that for mezzanine ABS CDOs, where the synthetic ABS product is most liquid, that volume on the synthetic CDO side will greatly outpace volume on the cash side this year," said Michael Lamont, co-head of U.S. CDOs at Deutsche Bank.
If this development pans out, it could go a long way toward helping CDO market volume withstand the drop in issuance of home equity paper.
Merrill Lynch research anticipates a 10% drop in cash CDO volume in 2006, to $140 billion. However, ML also believes total U.S. CDO volume will actually increase by $15 billion to an eye-popping $200 billion in 2006 - an 8% uptick.
The firm attributes that uptick, in part, to an expected 100% growth in the issuance of these new synthetic CDO vehicles, which, somewhat confusingly, go by the monikers "synthetic structured finance CBO" and "synthetic ABS CDOs."
While no hard statistics are available, market sources estimate about $10 billion to $15 billion in these new synthetic ABS CDOs have been sold in the U.S. during the four-month period ending last month. That's up from zero for any prior year.
"There will probably be even more synthetic ABS collateral in CDOs in 2006," said Mark Adelson, director of structured product research for Nomura Securities. "A likely driver of that growth is a decline in the issuance volume of home equity ABS during the year."
Foundation for a
new CDO arena
For investors who prefer to play ball in the ABS space, instead of the corporate bond market, the debut of this new security and the new ABS index are akin to building a new arena.
In the simplest of terms, utilizing a credit default swap, or CDS, is necessary to reference, or place a bet on, an underlying bond without having to own it.
The new synthetic CDO vehicles do not actually own the ABS collateral packed into them, but rather "reference" the underlying collateral synthetically by buying credit default swaps.
Corporate bonds have been the collateral referenced through the CDS market. A CDS market for asset-backed securities didn't exist before 2004.
The blistering pace of the home equity markets before 2004 seemed to create more than enough paper for CDOs to harness as collateral.
But the sudden increase in interest in building a CDS market for ABS occurred in 2004 "because CDO cash managers had difficulty sourcing collateral," for their cash-backed CDOs, said Vikram J. Malkani, co-founder of Glucksman & Malkani, which arranges structured transactions that help issuers achieve balance sheet efficiency.
The CDO market's momentum caught up to, and surpassed, the home equity market's pace. Suddenly, there wasn't enough ABS collateral to meet demand.
Market participants appeared to solve the issue by using CDS to synthetically reference the ABS instead.
"A synthetic structure gave them an effective position of owning ABS without actually having to purchase the underlying ABS bond for the CDO," Malkani said.
But all the activity aimed at creating a CDS market for ABS hit one snag in 2004 - deal terminology in the paperwork meant for corporate bonds didn't exactly translate, or even make sense, when applied to ABS securities.
However, by mid-2005 the International Swaps and Derivatives Association had new deal templates in place for asset backed securities, allowing the first CDOs synthetically referencing ABS to be issued.
ABX.HE index provides diverse trading
Fast forward several months and the ABX.HE credit default swap index saw its first trading session last month. This new index will allow for more diverse trading strategies in the single-name default swap market of ABS.
While not directly linked to CDOs in the synthetic space, the new index has the potential to "effect the synthetic CDO market in a pretty strong way, although it's not obvious what that will be, as trading has just begun," said Deutsche's Lamont.
Just as the Dow Jones CDX index, which tracks U.S. investment grade credits, transformed the CDO market a few years ago, "the ABS index will allow investors to express different risk views, both long and short, and that could transform the synthetic ABS CDO market," he said.
Most of the current activity around synthetic ABS CDOs will come from watching new issuance. However, enough liquidity is already present in the market for some of the new synthetic ABS CDOs to trade in the secondary CDO market.
"We have seen some of them re-trade already, so there is a secondary market for them. It's not as robust, but the liquidity is not that much less than for cash bonds," said Greg Lippmann, global head of CDO trading at Deutsche Bank.
Investors are using metrics similar to the cash market to value these synthetic brethren, including net asset value, cash flow and "stressing" scenarios, traders report.
"Since these deals are new, there are no distressed credits in any of them. The analysis, at the moment, is very simple, just NAV analysis and base case returns," Lippmann said.
It's too early to tell which particular vintages of ABS are the most popular by reference. And no one has yet to embark on packaging a synthetic ABS CDO that referenced below-investment-grade collateral.
"Conceptually there is no impediment, especially when you consider CDO squareds were originally done with triple-Bs, and then they went down to double-Bs," said a managing director at a CDO management firm.
The most compelling prospect for synthetic ABS CDOs currently is that they are not constrained by collateral volume. Theoretically, trillions of dollars in these new CDO securities could be issued because the underlying collateral never needs to be owned.
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