Derivatives 2006 - Tale of two markets
The market for credit default swaps on asset backed securities (CDS on ABS) has had mixed fortunes. In the US, the ABX, a CDS index referencing US sub-prime home equity and ABS, has exceeded expectations, while the CMBX, an index based on CDS of commercial mortgage-backed securities (CMBS), has underperformed. Europe has seen light demand. Jean Haggerty reports.
The European CDS on ABS market is seeing some trading, but it is still not a mass market. “[European CDS on ABS] spreads are pretty stable, so it is hard to take a clear view on spreads. Also, there is not a lot of difference in opinion on what will happen in the market,” said Krishna Prasad, head of European structured finance research at Lehman Brothers.
One of the key factors that has helped propel the US single name CDS on ABS market and uptake of the ABX since its launch in January is the wide range in opinions on what will happen in the US housing market.
“The million dollar question is: ‘How is ABS going to perform in a downward economic cycle?’ The other questions is: ‘Will CDOs continue to have a voracious appetite for this paper?” said Roy Cantu, head of CDS on ABS trading at Barclays Capital in New York.
In the US CDS on ABS market, Triple B assets trade at about 150bp and there is a lot of volatility to play with. In Europe, this is not the case. Spreads are often around 80-95bp for UK non-conforming issuers, and there is little difference between servicers.
“There is also little volatility because transactions have not been tested in adverse circumstances,” said Julien Mareschal, senior ABS trader at BNP Paribas. This is not to say there are no trading opportunities in European CDS on ABS. Dealers say that they are starting to see hedge funds and relative value traders put on place negative basis deals and other single-name CDS on ABS strategies similar to those that they put on in the US market about a year and a half ago. About 20 CDS on ABS names regularly trade in Europe, and roughly 75% of these reference obligations are UK obligations, mainly reference obligations linked to UK non-conforming issuers.
A European CDS on ABS index, akin to the ABX, does not exist, and the market for purely synthetic collateralised debt obligations (CDOs) of ABS has not taken off. There is no move to create a CDS on ABX index for the European market currently. “It is not clear that the underlying CDS are liquid enough to justify it just yet,” Prasad said. Based on how liquidity develops in the market, this may be an idea that is looked at again next year, other market participants said.
Some dealers in Europe have hedged ABS portfolios with the ABS 50, an index of Triple A ABS bond assets. The ABS 50 has not been liquid, in part because traders find it overly complicated. Additionally, it is based on physical underlying ABS assets, not on CDS on these assets. Going the synthetic route, when the underlying market’s liquidity justifies such a move, should result in a more user-friendly product.
CDS on CMBS may emerge as the CDS on ABS product that helps the most to develop a European synthetic ABS marketplace. “It has more volatility structurally, and so there is more chance that people would want to be buyers of protection,” said Rob Ford, head of European ABS at Barclays Capital.
Barclays Capital and Citigroup have been working with data and administration firm Markit to explore the feasibility of a CDS on ABS index for the European market.
Similar efforts in the US have met mixed results. CDS Index Company, the administrator for the CDX index family, and Markit in March launched the CMBX. Although a list of dealers including Bear Stearns, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Wachovia are trading the CMBX, the index is seeing little activity.
“There have been more sellers of protection than buyers of protection. Spreads have been pretty much a one way train (moving tighter over time) and technically driven by the CDO bid,” said Tony Butler, head of CMBS and commercial real estate research at Wachovia Securities.
According to Butler, the CMBX has had slower growth than the ABX primarily because of the availability of total return swaps for those wanting to hedge CMBS risk. “This has caused a slower migration or adoption. Spreads on CMBX have not correlated well with cash spreads,” he said.
The US ABS sector, on the other hand, has nothing else to choose from and therefore there was more interest in the product, Butler added. “At this point we do not see anything to drive more [clients] to use CMBX as a hedging tool given how poor the correlation has been,” he said.
As with CDS on ABS, dealers active in the US CDS on CMBS space are keeping their eye on developments in the CDO market. Most cash CMBS issuance is concentrated in the Triple A space, but the Triple B universe is where the greatest synthetic interest lies currently. CDO managers looking for Triple B paper are driving this demand.
“It is all driven by CDOs. When they are done buying, spreads will widen. And when they are active, spreads will tighten. Beyond this, we would need to see some credit events take place that would add some volatility into the system. Such an event would increase interest in the use of CDS on CMBS or the CMBX,” Butler said.
The CMBX index consists of the most recent 25 large CMBS deals with a deal size of over US$750m, a minimum tranche size of US$100m, a minimum weighted average life of 8.5 years and at least 10 borrowers. At launch, dealers were expecting hedge funds and money managers to emerge as a key audience for the index, which provides a way to short CMBS. Expectations were that money managers would be drawn to the high rating of the asset class and the ability to buy protection on a core long position, and that hedge funds would be attracted to trading strategies that could be built around the index.
The CMBX’s relatively weak reception since its launch this spring does not necessarily mean that its European equivalent will share the same fate. Dealers in Europe noted that in the US there is a greater consideration of risk at the bottom end of the US CMBS market and the CMBX targeted the top. More importantly, they point out, the underlying European and US CMBS markets are different.
Most US CMBS deals are granular in the way that they are structured. In Europe, by comparison, CMBS loans tend to be larger and less granular because the market is less mature. The European CMBS market, while growing fast, is still significantly smaller than its US counterpart.
What an investor is getting from CMBS in Europe and the US also differs. European CMBS do not trade with call protection on the underlying, so deals tend to have shorter maturities. Less homogeneous, single-dealer placed CMBS deals populate Europe’s less transparent CMBS market, and European cash CMBS assets tend to roll quarterly, while US assets roll monthly.
Few dealers have executed more than a couple of dozen single reference obligation CDS on CMBS trades in the European market, but it is becoming more active. The June release of a revised International Swaps and Derivatives Association (ISDA) template for credit derivatives on ABS with cash or physical settlement has helped boost activity in CDS on CMBS in Europe, officials say.
The relative inactivity in Europe’s single name CDS on CMBS space is not necessarily a hindrance to the creation of a European CDS on CMBS index.
Europe’s CDS on CMBS market will follow the development of the cash CMBS market, Ford said. Originating conduits are expected to step in as buyers of protection as they ramp up portfolios before a securitisation and as sellers of protection after they sell a deal.
Later this month, Barclays Capital, Citigroup and Markit plan to send to the group of eight dealers that have been contributing test pricing for a European CMBS index a documentation proposal for a European CDS on CMBS index.
A timetable for launching a European CDS on CMBS index has not yet been established, but a realistic target would be sometime in early 2007.
“The product that is proposed [this month] won’t be the same one that [market participants] have contributed test prices on, but it will have a number of similarities,” Ford said, noting that dealers continue to contribute those prices as the numbers give the market a data history.
“The original product that we started with was simple, and then it went through a number of radical changes and it became much more complicated, but now we have reverted to something more simplistic to ensure the broadest possible product acceptance,” he added.
Earlier incarnations of the index had no specified underlying reference pool. Instead, they had a synthetic underlying structure that referenced unspecified assets that fell into a certain set of criteria. “We need specified assets. We need to reference the real world,” Ford said.