In the pre-derivatives world, investors in mortgage-backed securities or real-estate asset-backed securities had two options: either to buy particular pools of collateral, or not to buy them. Shorting a position or buying protection were out of the question.
But by mid-2005 those limitations had changed as investors welcomed the birth of credit default swaps on asset-backed securities, known colloquially as ABCDS. These new synthetic instruments acted as credit default swaps on individual home equity issues in the market, giving investors exposure to names not previously available in the cash market.
Then the first set of synthetic asset-backed securities (ABS) indices was launched in January by the CDS IndexCo consortium and administered by Markit Group. Named ABX.HE, this index family references single-name credit default swaps of US sub-prime home equity ABS.
The partners joined again in March to launch CMBX, an index that references commercial mortgage-backed securities (see box overleaf). The ABX family has plans to further expand in 2006 to include credit cards, student and auto loans.
Brad Levy, acting chairman of CDS IndexCo and managing director of the e-business group at Goldman Sachs in New York, says the ABX.HE launch came in direct response to investors' increasing desire to take a synthetic view on ABS. "It introduced a standardised tool that allows clients to quickly gain exposure to the asset class," he says.
Participation in the ABX index has rapidly increased with volumes expected to double since active trading began in June last year, to some $200 billion according to Vikas Sarna, head of the ABS products business at JPMorgan in New York.
Like single-name ABCDS, the ABX.HE enables users to trade in a security without being limited to the physical outstanding amount of that security. But more importantly, it has given investors liquid access to the most frequently traded home equity tranches in a basket form. The ABX.HE uses five indices that range from triple-A to triple-B minus. Each index chooses deals from 20 of the largest sub-prime home equity shelves, by issuance amount, from the previous six months. The minimum deal size is $500 million and each tranche referenced must have an average life of between four and six years, except for the triple-A tranche, which must have a weighted average life greater than five years.
"It is a new liquidity pool focused around the idea of the credit of an entity or a structure: an entity meaning a corporate and a structure meaning an ABS," says Levy. "It broadens the ability to begin trading credit as well as people's ability to take or lay off risk around a specific credit."
In a CDS agreement, a counterparty with risk concentration in a particular credit, the protection buyer, enters into a contract to sell risk to another party, the protection seller, by paying a premium. Single-name ABCDS has allowed investors, dealers and issuers to short or hedge positions as well as transfer risk. "It has introduced a whole new dynamic into the marketplace because with CDS you can theoretically trade any bond that was ever issued from the long or short side. Cash bonds that haven't traded for years can resurface in CDS form. That has forced the market to evaluate bonds from a different perspective - in many cases a deeper credit perspective," says Roy Cantu, director of ABS at Barclays Capital in New York.
How ABCDS evolved
Historically, the asset-backed securities market was limited to cash portfolios, and non-standardised ABCDS were negotiated bilaterally between counterparties. Investors in mortgage-backed securities or real-estate ABS were mostly confined to either buying or selling long risk. There was no way to effectively short a security or to buy protection on an underlying collateral asset.
During the last few years due to the robustness of the cash collateralised debt obligation (CDO) markets, sourcing collateral and finding good value became a challenge. "Because you had 10 to 20 CDO vehicles ramping up at any given point in time - potentially all chasing the same limited supply of cash bonds - that produced a tactical bid for the paper which led to spreads being tight relative to the risk of those tranches," says JPMorgan's Sarna.
With synthetics, the sourcing becomes relatively easy, says Jeffrey Stern, partner in the structured finance group at law firm Stroock & Stroock & Lavan in New York. "A collateral manager can simply identify reference obligations to which it wants to take exposure and does not need to accumulate and warehouse large numbers of cash bonds. As a result, managers can create their portfolios quite quickly."
When the International Swaps and Derivatives Association (Isda) in June released its two templates for cash and physical settlement of ABCDS and the pay-as-you-go template, it laid down the foundation for the ABCDS market. Both templates provided CDS counterparties with standardised definitions for credit events and settlement mechanisms for the first time in the case of ABS reference obligations. Robert Pickel, chief executive officer at Isda, says: "It allows market participants to focus on the underlying economics and the logic of a trade and not get bogged down in the details of negotiation of confirmation."
But finding protection buyers in a market saturated by protection sellers has already posed a challenge. In its short life, the ABX has been used primarily as a hedging tool by lenders, dealers and hedgefunds. Flows in that market have been concentrated at the triple-B and triple-B minus level, and this is where most price volatility is in any given day. So far, the bulk of current transactions have focused on commercial and residential mortgage-backed securities and the market has been slow to tap into other asset classes, such as credit cards and student and auto loans where cash credit spreads are relatively tight.
But the biggest and the most consistent players of both single-name and index trades have been CDO managers. They use the instruments by selling protection to acquire assets and gain exposure to the underlying ABS instruments to fund deals. The market also lends itself to correlation traders who have found that the single-name market, underlyer bonds and index products enable them to hedge or take additional risk.
At present, Sean Rice, managing director of global structured products at Banc of America Securities in New York, describes the ABX index as a "liquidity magnet". In recent months, there has been a fair amount of liquidity that has moved out of the single-name market. Rice says that this has created a problem for some of the CDO managers who are currently trying to ramp up synthetic buckets or whole synthetic deals.
Barclays' Cantu agrees: "In the near term it has pulled out some of the liquidity from the single-name market simply because dealers have a limited amount of time during the day (to perform structural analysis on the underlying collateral). But the fact that you have cash, single names and the index is a good thing for the market and will bring more liquidity over the long run."
Customisation has also brought in new investors, such as participants from the origination side, says Thomas Priore, chief executive officer of the New York-based leveraged credit asset management company Institutional Credit Partners.
Mortgage originators and real-money managers are showing increased interest as corporate crossover accounts educate themselves about this new product. JPMorgan's Sarna says he receives five to 10 calls a week from potential clients in this group given the concerns of rising interest rates and a predicted rash of delinquencies in the residential sub-prime market this year and next. "That is definitely a market that they want to be a part of," he says. "Once these guys get familiar they are going to be playing in the space, and many of them already have transacted in size."
Jack McCleary, head of asset-backed trading and syndicate at UBS in New York, points out that mortgage hedge funds are using the index to express relative-value views between different originators, different vintages and capital structure arbitrage trades. "They may buy bonds that are very low rated and buy protection on tranches higher up in the capital structure," he explains.
CDS IndexCo's Levy says some market players are waiting on the sidelines to see how liquidity in the index market and on the underlying asset-backed names will play out. He adds that these entities may have to gain approval from boards and comply with investment charters before trading new products. "It's very natural to me that certain members in the market, both because of their mandate and their inability to trade the product, just need the market to evolve a little bit more," he says.
With both the single-name synthetic ABS market and the ABX index emerging within a relatively short space of time, some observers say this will allow both sectors to grow together, bringing further standardisation and efficiency to the products. "On the back of the ABX index is an actual standard CDS confirmation. And the hope is some of the standardisation will also be applied to the broader single-name ABS market," says CDS IndexCo's Levy.
In an environment where credit spreads on corporate bonds are tight and suffering from pressures such as leveraged buyouts, releveraging and M&A activity, the attractions of the ABX index, with its low exposure to credit losses on its higher-rated tranches, are obvious.
However, Peter DiMartino, head strategist for ABS/MBS credit and synthetic products at RBS Greenwich Capital in Connecticut, says that the evolution of the synthetic ABS market will eventually complement the corporate bond markets. "Using ABS gives credit risk managers 'secured' exposure to consumer markets. Doing it synthetically gives them an enhanced flexibility to be bearish or bullish and to tailor an appropriate trade that isolates a particular exposure in an ideal size," he says.
As new products develop, Isda's Pickel says market participants will have new ways of looking at risk, price and credit exposure. "It's a dynamic marketplace and new developments are always good because they provide more tools to investors," he says.
CMBX joins index family
The latest addition to the family of ABCDS indices came in March with the launch of CMBX, a range of synthetic credit default swap indices of US commercial mortgage-backed securities from CDS IndexCo and Markit.
CMBX consists of five tradable indices, based on the 25 most recent CMBS deals. Each of the indices is referenced to different rated tranches of CMBS notes: AAA, AA, A, BBB and BBB-. They are selected through an algorithm which identifies the most recently issued deals that meet the specific size and diversity criteria.
To qualify for index selection, the following criteria have to be met: deals must be secured by at least 50 mortgages that are obligations of a minimum of 10 unaffiliated borrowers; no more than 40% of the underlying mortgages can be secured by properties in the same state; and no more than 60% of the properties can be of the same property type.
Markit, a UK-based pricing and valuations specialist, will then poll CMBX dealers to verify the basket's liquidity. Markit will be responsible for the day-to-day operation of CMBX's rules and analytics. It will publish prices daily on its website, markit.com, using cashflows from Trepp, a provider of commercial mortgage analytics and technology, and will provide monthly fixed and floating payment amounts as well as supply a calculator for the settlement of trades. A new series of CMBX will be issued every six months.
"The market for CDS of CMBS has been growing rapidly for several months and we expect CMBX to provide market participants with new ways to take synthetic exposure to the CMBS market," said Bradford Levy of Goldman Sachs. "CMBX is a tradable benchmark that will give clients a liquid and standardised too- for trading and structuring."
The market-makers in the index are: Bank of America, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Nomura International, RBS Greenwich Capital, UBS and Wachovia.