Spreads on credit default swaps that protect against default of mortgage-backed securities are set to tighten in 2006 as collateralized debt obligations move to sell more protection in the sector. Frank Gianatasio, principal at State Street Global Advisors, predicted CDOs would be big players in the residential CDS market next year. "This, coupled with a decrease in cash supply, should cause spreads to tighten during the first few months of 2006," he said.
Credit default swap spreads in the residential real estate market started to widen in October after analyst reports predicted a slowdown in the residential and commercial real estate market. News of higher default risk caused hedge funds to short the sector by buying protection in the CDS market when credit spreads were tight.
The CDS market for MBS is a barely one year old. But its growth this year has enabled investors, such as hedge funds, to short the residential and commercial real estate market for the first time. The recent high demand for credit default swap protection has caused spreads to widen 150 basis points on subprime MBS tranches, which are now trading at around 325 basis points.
Spreads have since stabilized as collateralized debt obligations filled the gap in demand for credit default swap protection. But Gianatasio said the market can be volatile and spreads could easily widen further. "For the remainder of the year, spreads should stay where they are. The hedge funds and CDOs seem to be done for the year. But the market is very whippy. One or two large trades can widen spreads anywhere between 50 and 100 basis points," said Gianatasio.
Rising interest rates could make certain MBS transactions more vulnerable to default in 2006. The U.S. housing market has been stable for the past five to 10 years, but Gianatasio predicted it could be become more volatile because of the high amount of mortgage debt that consumers have taken on in the low interest rate environment. "Going forward, defaults could increase as interest rates rise and hybrid ARM mortgages become more expensive," he said.
Ben Logan, v.p. of product development at Markit, also predicted more volatility. "In the past month or so and since Hurricane Katrina, poor performance has started to show up in trustee reports, or at least people are looking for it more," he said. "The mortgage-backed securities market has performed well in the last few years. But, with rising interest rates and aggressive deal structures, investors are worrying about their investments."