The US home equity loan market has long been a fertile source of assets for ABS CDOs, offering a nice boost to yields in an otherwise frustratingly tight spread environment. But recent data from Moody’s and Lehman Brothers reveal that projected HEL rating actions in 2007 will almost double those since 2003, and those actions are all in one direction - down. Lehman is expecting about 700 downgrades of triple-B minus rated HEL notes in a 5% house price appreciation (HPA) environment and 1,000 downgrades if HPA is zero. The stark news for the industry is that the majority of mezzanine CDOs outstanding will likely experience downgrades in their portfolios in 2007. Roughly 20% of the sector has exposure to bonds deemed highly likely to be downgraded by 10% or more. It is interesting that the pain will not be confined to 2003 and 2004 vintages but will also be felt in relatively unseasoned 2005 and 2006 vintages. The downgrades are unlikely to result in trigger failure but might mean that a haircut will be applied to the par value of the asset when calculating the overcollateralization coverage test. This will have a sharper impact on the more recent vintages as the older deals have sufficient OC cushions to absorb the impact.
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