Investors and analysts are expecting the asset-backed market's next innovation to be the availability of default protection that could be used to effectively hedge portfolios of structured finance bonds. They say 2004 is likely to be the year when banks will be able to successfully structure securities that would act as default protection on ABS master trusts. "It's in the early stages and there's no place for it to go except to grow," says one head of ABS origination at a major underwriter. "It's definitely the most intriguing development out there," says another holder of securitized assets.
A synthetic investment would provide the major buyers of structured finance bonds with a way to protect their portfolios without taking on the basis risk posed by using traditional credit default swaps, as well as a method of shorting the special purpose vehicles that issue asset-backed bonds. "I've heard a few rumors on that; my guess is they will do it on issues you wouldn't feel you need to buy protection on to start," says one investor who has spoken to sell-siders attempting to structure ABS protection. She mentions high-quality credit card master trusts as examples of vehicles that protection could be written against to test the product's viability and says she would welcome this innovation.
But, the creation of a market to hedge ABS positions won't be as easy as the corporate default swap market, because there are no standardized definitions for default in the ABS market, according to experts. "Banks could write protection against a master trust," explains Janet Tavakoli , president of Tavakoli Structured Finance , a Chicago advisory firm. Yet she cautions documentation must be different for each reference entity to determine exactly what would constitute an ABS pool's default. "There's a question of if it would really catch on [because of the documentation issue] or whether it would be an accommodation to solve problem deals," she states.
Credit protection on ABS trusts is seen as necessary given the market's growth to roughly $400 billion this year. Furthermore, the occasional blow up of ABS issuers and their effect on master trusts proves that there is a need for an efficient risk management tool, according to industry professionals. "It will require a lot more work than the corporate [default swap] market, but that's not to say it won't evolve into a non-cash risk transfer market," notes one banker.
A handful of credit-linked notes have been sold in the last year or so and offer investors protection on a pool of jumbo mortgage-backed loans. But widespread protection on other structured finance asset classes is not readily available. However, it appears to be in demand to the point where Bear Stearns earlier this year started showing corporate default swap levels to its ABS investors (BW, 5/5).
