An increasingly popular variation on the CDO theme in Europe has been the development of CDOs of asset-backed securities, sometimes also referred to as structured finance CDOs. These structures generally securitise baskets of residential and commercial mortgage-backed securities, both of which have seen explosive growth in recent years.
According to the European Securitisation Forum, RMBS issuance in Europe rose by 18.7% in 2005 to EUR142.6bn, while the CMBS sector was the fastest-growing component of the European ABS market in 2005, with issuance of EUR37.7bn, more than double the total primary market volume in 2004. "The sharp increase in CMBS issuance can be explained by a very favourable commercial real-estate market that saw investors easily absorb the supply of new CMBS, characterised by rating stability and above-average coupon."
Cash CDOs of ABS, which first started to emerge in Europe in 2002, incorporate the structural features that are used in other types of cashflow structures, with most European transactions to date taking the form of mezzanine and high-trade deals. According to DrKW, by early 2006 there were some 33 public cash CDOs of ABS outstanding, managed by 15 different managers.
"Cash CDOs of ABS, in general terms, bring exceptional advantages for investors," explains DrKW. "As most of the deals contain large portions of RMBS securities, investors benefit from the backing of collateral with great rating stability, higher recovery rates and low historical default rates."
The bank adds: "All the structural features ... also protect investors enormously against losses in the pool of assets and, to the extent that the correlation between ABS bonds is higher than in corporate bonds, investors also gain from lower exposure to idiosyncratic risk. Lastly, investors also have a premium over corporate bonds for the same rating."
Synthetic CDOs of ABS
The market for synthetic CDOs of ABS took a very important stride forward in June 2005 with the publication by the International Swaps and Derivatives Association of a template for documenting CDS based on a pay-as-you-go approach. Isda announced at the time that "the template is designed for use primarily with a reference obligation that is a residential mortgage-backed security or commercial mortgage-backed security. It is anticipated that this template will be used mainly, but not exclusively, in North America, where these securities are more commonly referenced in a CDS on ABS transaction."
Europe has traditionally used physical settlement with a cash option rather than the pay-as-you-go template, which analysts believe will need to change if a more dynamic CDS of asset-backed securities (ABCDS) market is to blossom in Europe. "Given the complexity of ABS, the pay-as-you-go settlement system more truly transfers the risks than is currently achievable with the European settlement approach," observes Barclays Capital in a report published in December 2005. "The latter works fine for ABCDS as far as indices are concerned, but the eventual move to single-name CDS will require the European markets to either adopt pay-as-you-go or develop a hybrid settlement system."
Analysts agree that the advent of the market for ABCDS represents an important landmark in the evolution of the credit market because of the new range of opportunities it offers investors. As JPMorgan explains in an analysis published in March 2005: "The emergence of a single-name ABCDS market represents a major development in the evolution of the ABS market. To date, ABS has primarily been a long-risk, cash-only market. ABCDS will now enable ABS investors to take on risk synthetically. More importantly, ABCDS will transform ABS away from a long-only risk market and provide ABS investors, dealers and issuers with the ability to short the market, hedge positions, or hedge loan pipelines."
A number of analysts believe that this will become an increasingly attractive feature of the market in Europe over the medium term, given the spread tightening that has characterised European structured bonds over the last five years. That in turn has limited demand for protection against defaults, although that trend is not one that can last indefinitely, as Barclays Capital observes in its analysis.
"In general," notes the Barclays report, "market participants are concerned with the continuing tightening in credit spreads over the past five years. It seems clear that spreads are near their all-time tights and that a worsening credit environment (say as a result of a recession) could cause long-term spread widening for bonds. By buying protection, investors can lock in the current level of spreads (and gains made to date) and hedge against spread widening without having to divest and move into cash."
An additional driver of growth for the ABCDS market, believes Barclays Capital, will be the growing need among European CMBS conduit and CDO originators to hedge against spread movements between loan origination and capital market execution.
One by-product of Isda's initiative to standardise documentation for credit derivatives and ABS, according to a recent Fitch update, has been a growth in the market for cash and synthetic combinations. "Hybrid collateralised debt obligations, which have both cash and synthetic assets and liabilities, as well as managed synthetic CDOs, which have synthetic and cash liabilities but only contain synthetic assets, are appealing to a wider base of issuers and investors," the agency notes.
Commercial real estate
Commercial real-estate CDOs backed by commercial real-estate assets such as CMBS, commercial mortgage loans and REIT debt date back to 1999 but to date the market has been confined principally to the US. According to a report on the sector published by Nomura at the start of 2006, commercial real-estate CDOs entered into a new era of development in 2004 with the emergence of transactions that were backed by actively managed pools of commercial real-estate assets.
"At the same time," explains the Nomura report, "new types of unsecuritised collateral assets, such as B-notes and whole loans, began to appear as collateral assets. Many of these new assets are floating-rate instruments and can be prepaid after 12-18 months. In the past, buyers of B-notes and mezzanine loans often used short-term repo to finance these assets. Instead, by putting them into a revolving pool commercial real-estate CDO, these investors are able to obtain matched-term funding at a lower cost."
Interest in the potential of commercial real-estate CDOs in Europe is beginning to emerge. According to Fitch: "Deals with significant portions of commercial mortgage-backed securities have come to market in Europe, but to date there are no pure commercial real-estate CDO transactions with commercial real-estate loans as the primary asset class. Fitch has received preliminary inquiries on launching such deals and there are already European CDOs that contain a small portion of B-notes."
A number of other innovations have characterised the CDO market in the last 12 to 18 months, attesting to the market's dynamism and flexibility. One example is the forward-starting CDO, in which credit protection takes effect only after a predetermined period, during which time investors do not incur any losses arising from defaults.
The rationale behind the forward-starting formula is that it allows investors to exploit perceived inefficiencies in the credit curve, with steep credit curves implying short-term spread widening. In the early forward-starters marketed by banks in 2005, typical structures were based on seven-year CDOs with investors protected against losses in the first two years.
COLLATERALISED EQUITY OBLIGATIONS
A fledgling market for collateralised equity obligations (CEOs) started to emerge following the development of equity default swaps (EDS) in 2003. EDS work in a similar way to CDS, providing buyers of protection with compensation in the event of certain predefined credit events, with 'default' on an underlying reference asset in the EDS market deemed to have occurred if and when its share price falls below a certain percentage of its spot value.
That so-called 'trigger price' is generally 30% of the spot price at the time of the contract, although it can be higher: in the case of the CEDO deal from Credit Suisse First Boston in 2005, for example, the EDS is triggered when any stock within the portfolio falls to 35% of its initial value.
A variation on the theme of CDOs of EDS are reference pools combining equity and credit default swaps. Chrome ACEO (Alternative Credit and Equity Obligation), which references 90 CDS and 30 EDS and was launched in September 2004, was one of the first of these co-mingled products. In general, however, issuance of CDOs of EDS or blended CDS and EDS to date has failed to live up to the expectations of early market participants.