CDOs Pull Spreads in on Subordinate Tranches

Subordinated asset-backed securities have been shunned by investors since the financial crisis of fall 1998; fears relating to Y2K only made the situation worse. Resulting low liquidity and concerns over credit kept subordinate spreads at historically wide levels, despite a return in the on-the-run triple-A sector to sane levels, at least, if not normalcy.

However, with the bad memories of fall 1998 fading at last, and with the passing of Y2K, the subordinate market has started to come back to life. Limited new supply, light dealer inventories, and cash that was held off the market last year have combined to tighten HEL subordinates by 25 to 30 basis points in just the first few weeks of the new year. We believe that this trend will continue into 2000, and at a pace that may surprise many investors.

Two factors are likely to create the strong bid that we expect for subordinate bonds: the potential passage of Erisa reform, and the advent of CDOs backed by ABSs. On the surface, each force looks like it will broadly impact the entire subordinate market; however, they are likely to operate on different segments within the market.

Erisa reform, if passed, will be more like a shotgun: All subordinate ABS bonds (with the exception of some credit-card subs that are already Erisa-eligible) should benefit, but only to the extent that they are included in the new list of allowable investments. In the most-likely case, the list will include only double-A and single-A bonds. We expect limited spillover into the triple-B subordinate market due to the substitution effect - triple-Bs will become cheap relative to higher-rated bonds - but this impact should be muted.

The more interesting development for the sub market is the advent of ABS CDOs. Erisa reform is speculative, but there is little doubt about ABS CDOs; they are already here. The impact on the markets, however, will ultimately look like a narrow rifle shot when compared to the impact of Erisa reform.

The primary driving force behind ABS CDOs is arbitrage. In the short run, rapid growth will create a strong bid for all types of ABSs across the entire rating spectrum, since Y2K and the October 1998 debacle left so many bonds at distressed levels. But this initial broad level of demand may prove to be misleading. Once the overhang of distressed inventory is absorbed, the CDO bid will focus primarily on the triple-B sector, since that is where the most spread can be found. The few double-B-rated ABS bonds that exist will also see a pickup in demand, and it is possible that the advent of ABS CDOs might turn out to be the stimulus needed to encourage issuers to start creating more below-investment-grade ABSs.

Within the triple-B and (admittedly small) double-B sectors, however, demand from the creation of ABS CDOs will not be spread uniformly across asset types, because there is an additional force that drives the creation of CDOs - the need to obtain and maintain a high diversity score. The rating agencies, following standard portfolio theory, feel that broadly diversified CDOs are less risky. Diversity is gained by including bonds with different sources of risk.

For example, the source of credit risk in a B&C home-equity pool is fundamentally different than the source of risk in a pool backed by commercial jet-aircraft leases. The greater the diversity, the lower the cost of credit support. A certain amount of diversity is easy to acquire. Subordinate home-equity and credit-card bonds are in plentiful supply year-round, but triple-B aircraft-lease bonds can be impossible to find on demand. Few exist, and they are issued infrequently; but bonds like these are essential for building diversity. This implies that a disproportionate demand will build for the off-the-run collateral types, and we expect these types of bonds to experience the greatest degree of tightening as the ABS CDO market develops; there is no way to hit a reasonable diversity target without them. It is ironic that the bonds with the least liquidity due to small market size will likely experience the strongest bid and the most tightening.

One additional factor that will impact the subordinate market in 2000 is the fact that many home-equity pools will hit their clean-up calls this year. We estimate that this year, bonds with about $20 billion to $25 billion in original face value, or $2 billion to $2.5 billion in value at the call date, will reach the point at which they can be called.