Awake the CDO

Some parts of the CDO market are closed. According to Bloomberg:

Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry's largest conference.

``We're definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks,'' Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday [...]

The slowdown of the more than $2 trillion CDO market follows record downgrades in mortgage-linked securities last year. Some AAA rated debt lost all its value. [...]

Demand for new CDOs has stalled, with just one created in the U.S. so far this year, according to JPMorgan. [...]

Fitch Ratings today said it may downgrade the $220 billion of CDOs it assesses that are based on corporate securities. The New York-based company said it may lower the notes by as much as five levels after failing to accurately assess the risk of debt that packages other assets.

I bet the bar at the ASF resembles a wake at the moment. The closure of the markets for CDOs based on MBS, high yield and bank preference shares is predictable: that high yield CDOs are also effected is less so. I can't believe there are many ratings driven investors left so the Fitch downgrade should not change too many people's view of the tranches. It might change capital requirements, but that is not a constraint for most investors.

A different explanation for the CDO liquidity squeeze comes to mind: a rather more ordinary one. Investors are simply nervous about corporate credit risk. They expect default frequencies to rise in a recession, but they do not know how much. As FT alphaville points out:

The iTraxx Crossover index of mostly junk-rated corporate debt closed above the 500 basis point level on Tuesday for the first time, and on Wednesday morning pushed higher still to 515bp. The index hit its highest intra-day level, 530bp, during the global equity sell-off in January.

The iTraxx Europe index of investment-grade credits also hovered around a record, at 90bp in morning trade.

Investors will not be buying high grade CDOs until they have a goodidea how far this is going to go. That should mean that there are serious bargains (if not stately dress) in the secondary market for anyone willing to take a view on default correlation.

There should be similar opportunities in preference share CDOs. Certainly a first to default note on a basket of the prefs of too big to fail banks (Citi, BNP Paribas, Deutsche, RBS) could have a very attractive yield at this point.