The U.S. CDO sector, fueled by residential mortgage and leveraged loan collateral, grew by leaps and bounds in 2006 to an estimated $480 billion - posting a gain of roughly 57% over last year and establishing itself as a staple within fixed income.
And while market participants are not anticipating such a dramatic increase in 2007, they said that innovation and continued investor demand will likely sustain a moderate increase over this year's dollar volume.
"There is not a lack of imagination on the issuance side in terms of creativity," said Louis Lucido, group managing director in Trust Company of the West's credit mortgage group. Indeed, aside from the explosive growth in the use of synthetic technology in the CDO space, the sector this year saw deals incorporate such collateral as commodities and municipal bonds. And as the global search for yield marches on, CDO market participants are buzzing about the prospect of bringing CDO technology to Asia, ABX.HE and LCDS correlation as well as bespoke trades and the increasing use of market value structures, to name a few ideas on the horizon.
Underlining expectations for the sector, several CDO players are making a concerted push into the U.S. market next year, most recently Mizuho Securities (see story on p.11), the investment banking arm of Japan's largest bank, Mizuho Financial, and Calyon (see story on p1), a unit of France's Credit Agricole.
CDOs backed by trust preferred securities are also pegged as a growth area in 2007, as a slew of TPSs are expected to reach the end of their five-year non-callable periods. "I think trust preferred product will have a tremendous year," said Chris Ricciardi, president and chief executive of Cohen & Co. CRE CDOs constitute another corner of the CDO sector expected to post gains over 2006 issuance, as commercial real estate lenders continue to seek more efficient means of financing.
Alas, CDO manager tiering
The performance of subprime mortgage collateral, and to a lesser extent, certain collateral in CLO buckets, continues to loom over the sector like a dark cloud. Much to the delight of a number of CDO market participants, price differentiation based on such deal characteristics as manager, underwriter and collateral choice are expected to begin playing a much larger role in pricing. Amid a rosy credit environment marked by rapid home price appreciation and few corporate defaults, some say certain deals were done with collateral - even just a bucket of collateral - for the sake of yield that may not perform up to expectations.
"I think that there are some investors and managers that were not as discriminating about keeping within good sectors, or which specific assets they chose, and that could come back to haunt a few of the deals," one CDO market participant said. "I think a very small handful will realize some bad credit decisions, probably mostly true in the mezz ABS sector, and possibly in CLOs as well."
According to a 2007 CDO outlook published by JPMorgan Securities, a prolonged environment of negative home price appreciation could prod home equity loan losses to reach a level that would more likely result in a complete write-down on subordinate SF CDO tranches. "Though most SF CDO tranches would likely be money-good in more moderate slowdown scenarios, in our view the increased downside risk warrants greater risk premia down the credit curve in both HEL and SF CDO tranches," JPMorgan analysts added.
Capitalizing on uncertainty
The uncertainty of how the broader economy, and the Federal Reserve, would absorb the slowing housing market has the CDO sector looking forward to structures that will incorporate more flexible instruments, including long/short strategies. TCW's Lucido is expecting the theme of "impending doom" to carry on into 2007, if not intensify. The trend will result in more correlation and long/short trades, he predicted.
"I think the doom and gloom, this dire forecast for HPA, is not in the cards," Lucido said. While the magnitude of consolidation within the subprime lending industry, along with performance-related tiering are likely to surprise the market next year, he said the "resiliency of the economy, in and of itself, will mitigate some of the evils that come into the market."
In fact, according to one market participant, the eagerness on behalf of hedge funds to short the home equity sector, and its resulting effect on hybrid and synthetic ABS CDO issuance, could actually be a driving force in ensuring liquidity is available for subprime lenders needing to refinance mortgages for subprime borrowers.
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