Housing Market and Asset Backed Securities

The nuts and bolts of housing related credits by Pengfei Xie of EIM

Pengfei Xie, EIM
Originally published in the February 2007 issue

Having been cautious about credits for nearly two years, we have not been outright short. Is it time to finally become a credit bear coming into 2007?

Credit bulls will not agree. Banks and hedge funds continue to extend credit lines to lower-rated corporations, keeping corporate default rates below long-term averages. Flushed with hundreds of billions of fresh capital, private equity firms are hungry for deals, which, despite their potentially detrimental effects on credit quality, have injected liquidity and provided the “glue” that binds the market together-one of the reasons that the peak of the credit cycle has been prolonged. Remember the go-go years of the late 1990s? Credits did not really correct until a couple years later.

Corporate credits aside, what could happen to consumer credits if the real estate “bubble” bursts? According to some analysts, consumer defaults will mount and asset-backed securities (ABS) backed by sub-prime home equity loans, some $1.2 trillion outstanding, may experience large write-downs, which could put to bed the “great” credit rally that started in late 2002.

A World of Polarization

It is never clear-cut when it comes to the housing market debate. There is a polarization of views between the housing bears that fear for an imminent meltdown and the bulls who believe that any correction will be some time away, short-lived and local (rather than national). The bears could not have been more outspoken with their views frequently featured in the media.

Where does this leave housing-related credits? One thing is clear: uncertainty. Some argue that BBB- rated ABX 06-2 (an equally weighted index of 20 sub-prime ABS), trading at 450 bps over Libor on January 10th, should widen by another 400 bps in 2007 to justify the weak fundamentals, while others have kept the powder dry and see any such widening as much-anticipated buying opportunities.

What would make us negative? Either a final capitulation by the credit bulls (the pensions, insurance companies and more importantly, CDOs) or a material and unexpected weakening in housing fundamentals. In the meantime, we are conscious that technicals could overwhelm fundamentals and become the dominant force over a sustained period of time.

Fundamentals vs. Technicals

Economic data cited by housing bears may well be pointing to a “doomsday” scenario. Assuming a flat home price appreciation (HPA), losses on sub-prime pools are estimated to be 8% and if HPA is negative, losses could reach 12%. Since BBB- rated sub-prime ABS will be hit at the 8-10% loss level, it has become popular to put on shorts, primarily via ABS synthetics such as ABX, single name ABS and mezzanine tranches of ABS CDOs.

Favored by macro funds, dedicated short credit funds and even long/short equity funds, the heavy protection buying has pushed spreads wider, particularly in the synthetic index market (e.g., ABX). In addition to the systemic spread widening, tiering has increased between high and low quality ABS within same credit ratings.

On the other side of the bearish trade, demand from outright long accounts and CDOs is keeping the widening spread in check, but so far not enough to offset the widening.

BBB- rated cash bonds, single name CDS and ABX have behaved very differently, with the former two widening much less, at 175 bps and 150 bps tighter than ABX, as of January 10th. Spreads between the three had not been much apart until mid-2006. What has caused the large divergence? It would be hard to blame it all on the fundamentals as all three are BBB- rated referencing the same 20 deals.

Technicals provide a much better explanation. The clientele of ABX are mostly hedge funds that have not been historically known for picking individual credits. Moreover, after a 40% drop in the S&P 500 Home Building Index in the first half of 2006, it looked like a much better idea to short the housing market by buying protection on BBB- ABX (then 250 bps over Libor).

By contrast, the clientele of cash and single name CDS are outright accounts and CDOs, which do not typically go short. In November of 2006, a few large OWICs (Offers Wanted in Competition, or widely distributed lists of individual bonds to be shorted) from hedge funds surprised the market and finally pushed cash and single name CDS spreads wider, albeit to a much lesser degree than ABX. In December, cash ABS spreads narrowed while others continued to widen, which fundamentals alone fell short to explain.

It is surprising that the wide divergence between spreads of cash bonds, single name CDS and ABX has not been arbitraged away. Inhibitive transaction costs might be the reason (ABX bid/offers are 4-5 bps, while cash ABS bid/offers could be 25 bps on weak names). Nevertheless, the arbitrage for CDOs has become much more attractive-equity IRRs of synthetic ABS CDOs have increased to 20% due to wide spreads and “sticky” liabilities. Relative to the previous 13%-15% IRR, the increase in return is enough to entice many to step up buying. For example, the already robust CDO new issue pipeline is becoming even stronger, and a number of hedge funds have been busy launching ABS CDO equity funds.

In summary, weak housing fundamentals mean losses, but the liquidity provided by CDOs and long accounts can ensure that a greater percentage of borrowers stay in their homes (rather than default). As long as the technicals remain strong and fundamentals have not fallen precipitously and unexpectedly, shorting the housing market via synthetics does not seem to be the best trade in town.

Synthetics as a Means of Shorting

Since their debut less than two years ago, single name ABS CDS and ABX have quickly become liquid ways of going long or short housing credits. Unlike corporate CDS, the pay-as-you-go (PAUG) structure of ABS derivatives is something new and among the various risks, some are:

  • Basis risk. The “one credit two spreads” phenomenon is more pronounced in ABS, as shown in Chart 1. As technicals come and go, P&Ls fluctuate randomly with no apparent fundamental reason, which we do not believe is a risk well compensated for.
  • Structure risk. When GM and Ford were downgraded in early 2005, funds that were long CDO equities and short mezzanines (or selling protection on equities and buying protection on mezzanines), seemingly hedged against downgrades, were caught by surprise. CDO equities sold off while mezzanines rallied despite having the same collaterals-the structures of the bespoke deals put no pressure on mezzanines. And the fact that most mezzanine investors were buy-and-hold investors further increased mark-to-market values of mezzanines.

    Many short-biased funds are long CDO equities to offset negative carry. Could a “double whammy” happen again to the “long equity and short mezzanine” trades? Although many argue that ABS are different than corporate credits when it comes to default correlation, we are yet to be convinced.

  • Negative carry. The negative carry is substantial before any final pay-off. A 10x levered short credit fund that started trading in mid-2006 could spend Libor + 250 bps on BBB- ABX Index and easily incur 25% negative carry (as leverage levels vary, so does the corresponding negative carry). The actual carry will be smaller due to cash and other returns, but will likely exceed 20% per annum after management fees.
  • Individual deal performance has diverged significantly in ABX 06-2, as indicated by the 60-day plus delinquencies ranging from 0.80% to 10%. Buying protection on a diverse pool is a blind betagainst weak, but also solid credits, which are the majority of the index. This is a sub-optimal way to invest at best.