By in large, savvy market players seem to favor the CDO of home equity bonds over the underlying bonds themselves, given the added structure, mix of issuers and regions, as well as the pick up in absolute yield. While three-year triple-A home equity-focused CDOs are pricing within a few points of comparable HELs -both currently in the mid 30s - the CDOs are indexed off the three-month Libor compared to the one-month Libor, which picks up about 25 basis points on today's curve.

As a general trend over the past several quarters, structured finance CDOs have shunned sector diversity for sector expertise. This vintage of SF CDOs are particularly heavily concentrated, as investors seem to like these as much as the less homogeneous "real estate" CDOs, which often pack REIT, CMBS and RESI collateral in the same structure.

Not everyone is rosy on this trend, however. "It's very simple to me," said one investor. "Diversity, as a concept, has always been said to be a good thing because it limits your exposure. Why does home equity get a free pass?"

To be sure, the home equity CDOs are absorbing the most volatile slice of the home equity market - the triple-Bs and down (with the lowest tier at double-B). If there were a sector wide disruption specific to the current vintage of home equity, which

"These CDOs are fine if you don't do home equity, but want exposure to home equity," the same investor said. "But if you have a sector-wide problem, it might not make it to the triple-A of the home equity bonds, but it could get to the triple-A of the CDO."

With an improving economy, there aren't many reasons to be bearish on home equity, analysts say, although some are concerned that an overly aggressive cycle of originations may reveal itself, as lenders compete for a trickling base of borrowers. The biggest concern, however, is that home equity deals could breach the available funds cap, which would divert excess spread for the benefit of the seniors. Of course, adverse selection is always a concern when several CDOs are chasing the same collateral.

According Susan Barnes, managing director in the RMBS group at Standard & Poor's, triple-B home equities typically have about 5% or 6% credit enhancement underneath them, while the double-Bs are more in the 3% range.

Diversity for diversity's sake

This trend towards greater concentration is exclusive to structured finance CDOs, and not an issue in the other currently active sectors, namely high yield loan CDOs, said sources at Moody's Investors Service.

With good reason, perhaps, investor appetite is driving this phenomenon in the SF CDOs, as the early vintage (1999-2001) SF CDOs left a bad taste in the market's collective mouth. These deal are, and were, often criticized for their reliance on diversity to achieve ratings credit. Because of this, managers moved into sectors outside their expertise, which - for the more attractive return - included all of the later-to-be distressed sectors, such as aircraft, mutual fund fees, manufactured housing and franchise.

"All of those deals had a multitude of different sub-sectors," said Armand Pastine, a managing director at Maxim Group, a boutique firm. "The problem was that the likelihood of a blowup for a manager outside his sandbox was greater than in the sector he knows."

While the market currently favors the sector specific, highly concentrated deals, the rating methodologies have not changed in any significant way, Moody's said. "For the same rating, you have to have more subordination to counter the lower diversity score [in the deals currently being structured]," said Gary Witt of Moody's. "We would still rate deals that had higher diversity scores, there just doesn't seem to be the appetite."

Essentially, holding the real estate CDO is taking on industry exposure but is more likely mitigate a loss tied to any single issuer's misfortunes. For the CDO to get hit, the nature of the disruption would likely have to be industry-wide.

"If you did a solely home equity CDO in 1994 or 1995, you'd have an entirely different boat," said the skeptical investor. "At the end of the day, there's something to be said for diversity."

Structure versus liquidity

Meanwhile, there are plenty of supporters for both the underlying home equity bonds and the home equity focused CDOs. Both have their merits, apparently. One investor likes the innovations built into some of the CDOs from this niche, such as the fast paying subordinates seen in a few of the real estate deals managed by Credit Based Asset Servicing and Securitization (C-BASS).

More generically, others tout the added structure and enhancement in the CDO, versus the collateral. For example, Dan Castro, head of structured finance research at Merrill Lynch, favors the protection in structure. At the triple-A level, he said, the real estate CDO is backed by the enhancement under the triple-Bs in the collateral, plus the enhancement of the CDO up to the triple-A, which is in the 25% to 30% range. "There's no question that the CDO compared to the underlying collateral is going to be better," he said.

For the subordinates, views differ, even among the CDO proponents.

"Looking at triple-B home equity and looking at triple-B CDO, you're better off in the CDO," Castro said. "If you buy the CDO, you have all the protection embedded in the underlying bonds, plus all the protection in the CDO structure."

In an up market, said Maxim Group's Pastine, the CDO is the better bond. In a down market though, Pastine would rather be in the triple-B home equity than in the

triple-B CDO.

"I would argue that in terms of mitigating losses, owning the home equity would provide a higher degree of liquidity," he said. "At the subordinate level, sometimes your greatest mitigator of loss is the sale of the bond."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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