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Real Estate CDOs Find Favor
Total Securitization -- Institutional Investor News (April 7, 2003)

Real estate-backed collateralized debt obligations are one of the brightest spots of the CDO market, say analysts and buysiders, as more and more deals are getting backed with residential mortgage-backed or commercial mortgage-backed securities collateral, or a combination of both. One of the main reasons is because real estate has held up well in this recession and is still downgrade-free, unlike corporate bonds or sub-prime asset-backed securities such as aircraft, manufactured housing or tobacco bonds, which have recently been hit by negative stories. Real estate CDOs by definition are multi-sector deals in which the collateral is a mix of CMBS, RMBS, REITs and asset-backed securities. In a recent trend, the ABS component of the collateral in those deals has been reduced and the real estate buckets have increased, sometimes up to 100%.

Several factors contribute to drive this trend. Sheldon Sussman, global head of structuring for Rabobank International, underlines arbitrage, pointing to RMBS where spreads are attractive. "Residential deals are getting done because you find the paper, it's diversified and the arbitrage is there," he says.

Anthony Thompson, head of CDO research at Deutsche Bank, notes that in the first quarter there were $2.3 billion of new real estate CDOs issued, accounting for 35% of the global CDO market and 59% of structured product CDO issuance. The 35% share compares to 12% of volume in 2002 and 4% in 2001. He emphasizes that regulatory or legislative changes have benefited these structures. For instance, he says CMBS backed-CDOs were helped by last year's terrorism insurance legislation, a timely factor as Sept. 11 had put on hold the sector.

Another factor, Thompson adds, is FIN 46, the new regulation on consolidation issued by the Financial Accounting Standards Board. He says real estate CDO originators-typically CMBS servicers- have not been affected, unlike other CDO managers. Real estate CDO managers are typically indifferent to consolidation issues, either because they are not publicly traded companies or because they retain all of the equity.

Ron D'Vari, director of fixed-income research at State Street Research, says the appeal of real estate collateral is due to people's disappointment with the performance of the credit market. He reasons that equity investors have lowered their equity return expectations, looking for a type of collateral that has not yet been hit by downgrades. A few years back, he says, a high yield CDO deal targeted at 20-22% return for its equity investor. In comparison, a 10-12% return for a real estate CDO equity investor looks pale, but, "In these times of uncertainty, people settle for less equity return and a greater stability of collateral"

"The trend is towards more specialization, less diversification [of the collateral]" predicts D'Vari. "Looking forward, you are going to buy what you know." Deutsche Bank's Thompson sees deals entirely backed by real estate collateral with the elimination not the reduction of the ABS buckets, in the model of Crest Dartmouth Street CDO, Newcastle CDO II or Crest 2003-1. -Emma Trincal



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