Trust Company of the West's credit mortgage group, led by group managing director Louis Lucido and charged with managing more than $26 billion in assets, recently took time to answer questions on the state of the U.S. housing market, new CDO structures hitting the market and expectations on investor demand. TCW, based in Los Angeles, is the world's largest CDO asset manager.
U.S. Housing Sector
ASR: What is your outlook for the U.S. housing market in 2007?
TCW: While some overheated local markets are due to correct, the country as a whole likely will experience slow-to-flat property appreciation in the years ahead. Evidence suggests the market has begun to slow. The U.S. House Price Index appreciated at an annualized rate of 9.1% in the first quarter of 2006, versus a year-over-year increase of 12.5%. California, the largest regional housing market, posted annualized appreciation of 10% in 1Q06 versus year-over-year appreciation of 19.2%. Houses for sale are staying longer on the market. Builders are filing fewer permit applications. In our view, this is a normal supply-side correction. On the national level, year-over-year property appreciation remains positive and above long-term historical averages.
ASR: How, if at all, have changes in the U.S. housing sector affected how you manage your CDOs? Are there certain asset types that you are avoiding?
TCW: We believe a period of slower home price appreciation lies ahead, with the potential to weaken consumer spending. SF CDOs could see weaker asset performance due to consumers' stretched home equity financing, lenders' relaxed underwriting standards and higher-risk home loan products. A comprehensive credit process, including ongoing due diligence efforts and on-site meetings with issuers, is key for managers to understand the risks of prospective or existing investments.
As we anticipated, some tiering is already occurring in the RMBS market, and we anticipate further market differentiation in collateral as the credit cycle deteriorates. Investors are considering collateral quality and performance as well as structure and issuer/servicer historical record as indicators of value. Moreover, the wider use of CDS has increased market liquidity, which indirectly makes tiering more evident.
Definitions of credit criteria and underwriting guidelines vary across issuers of securitizations. An issuer may initially appear to have strong underwriting, but on closer review, we have found examples of exaggerated collateral characteristics. Furthermore, creative affordability products have added another potential source for varying credit.
ASR: Some people are predicting challenging times ahead for CDOs backed by U.S. real estate. How would you refute this view?
TCW: Supply. Global CDO issuance appears on track to set another record for volume in 2006. Through the first half of the 2006, total CDO issuance in the U.S. was $131.6 billion. We believe CDO issuance will be over the $300 billion mark for 2006. Actual issuance could be more as many CDO managers are waiting for spread widening to source collateral.
Demand. A key source of incremental demand for CDOs and other securitizations is the phase-in of Basel II, the new framework setting regulatory capital requirements for European financial institutions and U.S. banks with assets greater than $250 billion and foreign exposure greater than $10 billion. Basel II significantly lowers risk weights assigned to higher-rated assets (see Basel article p.17). This should boost returns on capital invested in senior CDO tranches and thus demand for this investment category. Additionally, the continued and seemly continuous process of dollar recycling has led to investment in these asset types.
Structural Innovation
ASR: Are there any new structural trends you see happening within the CDO sector? What about new asset types?
TCW: We have recently seen a series of transactions sponsored by a large hedge fund investor. These transactions don't have regular IC/OC tests, thus are more appealing to equity investors.
Structured finance CDOs, both cash flow and synthetic, experienced explosive growth, with synthetic arbitrage CDO issuance expanding relative to cash flow. The advent of synthetic SF CDOs came at a key juncture in securitization markets. Collateral sourcing had grown increasingly difficult amid keen competition for the limited supply of cash assets. Credit default swaps (CDS) enabled collateral managers to gain synthetic exposure, eliminating the need to hold the underlying cash asset.
Synthetic exposure also allows speedy issuance of CDOs to better capture changing market conditions, including spread conditions in the CDS versus cash markets. In the SF CDO space, issuers have found that they can more efficiently source mezzanine RMBS and CMBS in synthetic form than in the cash market.
Hybrid CDOs, transactions with both synthetic and cash assets and liabilities, first appeared in 2005. With their expanded issuance in 2006, the distinction between cash flow and synthetic CDOs is fading. We believe the convergence of cash flow and synthetic forms is the inevitable next phase in the evolution of the CDO market.
The catalyst for these structures was the 2005 release by the International Swaps and Derivatives Association (ISDA) of the ABS CDS template using Pay-As-You-Go (PAUG) or physical settlement. The PAUG option became necessary because of the inevitability that credit events will occur in which the notional CDS exceeds the par amount of reference cash assets, making sole physical delivery impractical. This standardization increased transparency to the cash settlement process and should increase market efficiency.
Unlike earlier synthetic transactions, hybrid CDOs and managed synthetic CDOs both incorporate coverage triggers and cash flow waterfalls as normally seen in cash flow CDOs. Therefore, they have mechanisms to trap cash on coverage test failures during the amortization of liabilities. Hybrid transactions have two segregated principal waterfalls: one for cash amortization and the other for synthetic amortization. In hybrid transactions, part of the proceeds from funded notes can be put in a charged asset account. The remaining portion can be used to purchase cash securities. Thus the manager has the flexibility to increase or decrease synthetic exposure relative to cash depending on basis spread opportunities.
We observed last year that hedge funds were becoming an increasingly important player in the ABS market (a trend we expect to continue). In late 2005, a number of large hedge funds bought protection on lower BBB rated home equity and sub-prime RMBS, and spreads had widened sharply for a short period of time. Although the volatilities largely resulted from technical rather than fundamental developments, it indeed has helped reinforce the trend toward cash and synthetic convergence. Investors have become more vigilant in exploring cash versus CDS basis spread opportunities.
ASR: TCW has come to the market with some innovative deals recently. Which ones would you say got the most positive reception in the market, and why?
TCW: Hybrid structures, as mentioned above. (Also), long/short strategies have added new twists to an already exciting market. Over the last 12 months, we have seen innovative and differentiated structures with long and short capabilities. This new development has enabled managers to better exercise defensive strategies across different credit markets. For example, a long portfolio focused on investment grade RMBS and other ABS, coupled with short corporate indices, allows the manager to extract value from shorting corporate risks associated with the auto sector, interest rates and regional property markets.
ASR: What can the market expect from TCW from now until year-end?
TCW: We look to continue with extensions of our existing product offerings. And provide innovative structures when we believe opportunities present themselves.
ISDA/ABS CDS
ASR: There has been a lot of discussion about the state of ISDA documentation for ABS CDS. How is standardization progressing?
TCW: The ISDA has yet to come up with a standard confirm for loan-only CDS. In February 2006, an ad hoc group completed a proposed template confirmation for loan-only CDS. The template is under review by the rating agencies. It might not be long before we start to see series of CLO transactions backed with 100% loan-only CDS. Other developments could follow as well, including an index product for leveraged loan CDS, which should present a sensible hedging strategy for a CLO equity investor.
ASR: How do you think the ABS CDS market will continue to change the CDO sector?
TCW: The increased use of derivatives in the ABS market was further propelled by the introduction of ABX.HE in January 2006. The index was aimed to facilitate CDS market development by improving liquidity and enabling macro hedging and taking macro views of the credit market. Investors can use ABX.HE to express macro views and engage in arbitrage trades across rating classes and vintages.
The launch of ABX.HE, which references 20 home equity securities, has further increased the hybrid and synthetic CDO manager's flexibility in investment and hedging. Dealers are committed to providing prices on the ABX.HE at least once a month, increasing market liquidity. However, ABX.HE, being an index, has limitations. Unlike single-name CDS, ABX.HE does not have coupon step-up; it has only a fixed available fund cap (AFC) and no variable AFC.
Macro hedge funds, which used to utilize single-name CDS, can now turn to ABX. HE index. It remains to be seen to what extent this will impact the liquidity of the single-name CDS market. This uncertainty is reminiscent of the early stage of the corporate CDS market. The ABS index likely will evolve at a fast speed, and the market likely will gravitate toward normalization as the investor base grows and liquidity improves.
Policing
ASR: As the CDO sector continues to grow, are you anticipating more of a regulatory presence? If so, what would that take the form of?
TCW: We believe that a process of self policing has been evolving, and that the American Securitization Forum, in conjunction with the Bond Market Association, is looking to "level the playing field" through education and developing a process of investor awareness. We perceive Federal intervention will only result if a large constituency is maligned by current market practices.
TCW Senior Vice Presidents Sajjad Naqvi and Shirley Zheng, along with assistant vice president Nanlan Ye, contributed answers to this article.
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