Friday, 21 September 2018

Securitisation 2007: Strong after the ABS meltdown, CLOs may yet lose their leadership

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The US CDO market, long a natural buyer of subordinate ABS securities, has been forced to shift gears as the US sub-prime housing market collapse has eroded the arbitrage between cost of collateral and selling a deal. Investors, still laden with capital, have shifted strategies and have purchased CRE deals and cashflow-backed offerings, but a return to short-term stability in the ABS markets may rekindle mezzanine ABS issuance. John D’Antona reports.

While the troubles surrounding the US ABS market and the sub-prime mortgage sector were well documented in the mass media, the residual or spillover effect in the derivative CDO market was less talked.

The largest single buyer of subordinate US ABS bonds, according to Fitch data are CDO asset managers who are accorded with purchasing 70% of subordinate ABS bonds. These lower-rated, higher-spread ABS tranches are ideal paper to make CDO deal creation economically viable. But, the sector has begun to feel the pain and Wall Street's once high flying sector has seen issuance slow from 2006's breakneck pace.

As a result, ABS CDO issuance dropped off to a trickle and cashflow CLO issuance took up the slack. Strong loan market fundamentals, such as credit loan performance, favourable earnings reports and voracious European demand, has helped the sector emerge as a saviour of sorts, keeping CDO structurers busy and the profit machine rolling. Over the last three-months, according to IFR data, US CLO issuance outpaced ABS CDO issues by a factor of eight.

But, with CLO issuance dominating supply, as virtually all Wall Street underwriters have sponsored deals, supply finally outstripped demand.

With all the competing deals, issuers have had to offer extra spread to get them placed.

"While no underwriter really wants to admit their deal requires extra yield to get done, it is happening. This is simply a situation where supply and demand are in a state of disequilibrium as so far there is little trouble within the loan space and with loan credits," a New York banker observed.

The recently completed US$850m Venture VIII offering from MJX Asset Management, a well-respected asset manager, had to add extra spread as an incentive for the lower-rated liabilities.

Given the demand/supply mismatch, the deal already posed a challenge in light of its large size. Triple B guidance at one-month Libor plus 235bp represented an additional 65bp concession from initial marketing levels.

In February, a similar quality deal, Gallatin 2007-1 for Bear Stearns Asset Management had a Triple B tranche that priced at one-month Libor plus 125bp.

For comparative purposes, a year ago spreads in Triple B rated CLO tranches priced in the one-month Libor plus 168bp to 172bp area.

As one market observer noted: "The kicker is that there is still more to come, near term." He noted that strong CLO issuance in 2006 was almost double 2005's levels: "Supply didn't pose much of a problem for spreads last year, but the supply/demand dynamic is not as balanced today, courtesy of the sub-prime fiasco."

US funded CLO issuance in the first quarter of this year was US$26.3bn. The sector reached US$101.72bn in 2006, according to Bear Stearns data.

In spite of this recent widening, CLO asset spreads remain close to their historical lows, it is more on the liability side, the loan market's largest funding source, where spreads have widened. Increased relative value versus ABS has probably sapped demand and led CLO investors to demand higher premiums. This has caused an erosion of the asset/liability margin for CLO managers.

"It is pure mathematics, if liability spreads are going up and asset spreads have not widened in tandem then there is an [arbitrage] erosion," said Karan Chabba, a CDO analyst at Bear Stearns. Arbitrage erosion occurs when there is a rise in the cost of acquiring collateral, servicing the collateral or management fees.

The demand for higher liability spreads is trickling down from the sub-prime meltdown and its impact on the ABS CDO market, where spreads have widened dramatically. "So investors in CLOs are saying: 'If the signal from other sectors is that risk premiums have increased, maybe I should be demanding a bit more premium'," he said.

Whatever the ultimate result of the widening in CLO spreads, CLO managers will do what they can to make their arbitrage attractive. The squeeze in margins means that CLO managers and investment banks will be more motivated to mitigate the effect of pricing trends by making slight changes to the structure of financing vehicles.

"There are other components that you can move around to make the structure work, like decreasing some of the fee in the structure," Chabba said.

A greater threat to CLO managers is increasing loan default rates. Liability spreads are important, but default rates are still viewed by managers as the factor that could ultimately change the market. As defaults arise – and they will – the eventual downgrades will put pressure on the way CLO managers do business.

But for now the CLO and loan markets are taking a wait-and-see approach. "Given the past three years there has not been much going on in the CLO market," a portfolio manager said. "This is the first time we have seen something different: It is not raining but there are clouds and people are talking about it."

Potential problems could arise from the increased usage of so called "covenant lite" loans, which are underwritten to less stringent criteria. These loans, some analysts believe, could underperform in a stressed credit environment.

And if storm clouds are being seen on the CLO horizon in the form of wider spreads and rising defaults, the skies may well clear in the ABS CDO sector. The once steady unending deluge of negative headline news, such as lender bankruptcies, shrinking credit lines, warehousing concerns, poor loan performance and plunging profits, is already starting to abate, though sizeable portion of that community say it will be sometime before the market completely stabilises. Nevertheless, a degree of relative calm has allowed investors and issuers to nervously dip their toes back into the ABS waters.

"The tone has improved in the ABS market, led by renewed demand for home equity ABS from high grade structured finance (SF) CDOs, reduced supply in the cash market, some stabilization of credit performance and hopes for at least marginal efficacy of the loan modification programs which have become a more prominent part of loan servicing," said Christopher Flanagan, head of ABS/CDO research at JPMorgan. "The pipeline for high grade SF CDOs is currently near record highs, having built up as spreads gapped out wider."

And further along the credit curve, Flanagan noted the mezzanine SF CDO pipeline, currently far off the issuance highs observed in the third quarter of 2006, told a different story. Unlike in the past, the most recent bout of widening in subordinate home equity ABS has yet to stir up buying activity. CDO managers have been slow to return, but he holds optimism they will return. The mezzanine CDO market experienced a precipitous drop in monthly issuance in April US$3.5bn versus US$13.5bn in March, the lowest month of mezzanine issuance since November 2005.

"Our longer term outlook on housing and subprime remains negative. However, favourable technicals, due to declining cash supply and a re-emergent CDO bid, and a low likelihood of sharply worse credit performance over the next few months suggest to us we are in the midst of a multi-month period of relatively low spread volatility" and increased issuance," JPMorgan's Flanagan said.

Lehman Brothers research wrote recently that it has taken just over two months since the February spread blow-out in CDOs to see the full impact, that recent events in subprime have had, on the state of the mezzanine CDO new-issue market. Regardless of a short-term increase in mezz or high-grade CDOs Lehman's has not changed its forecast for CDO issuance to decline significantly in 2007.

Analysts at Bank of America, who take a more short-term view, reported in it recent trading note that its trading desk had seen CDO issuance pick up, both from its proprietary trading desk and origination groups. It also noted that, in index trading, the ABX had seen increased flows with buyers solidly outpacing sellers.

"Activity has picked up tremendously as flows and rallies were seen on the Triple B- area,' it wrote. According to several market professionals, the ABX 2007-1 BBB- index gained just over three points in one week during May to close at 71.21. The ABX 2007-1 Triple B index closed up one point at 78.7, both pointing to stability in the most widely used CDO collateral pool.

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