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Bulls in a china shop

The ability of the CDO bid to distort the wider capital markets is significant – and growing.

Taking a bearish view of the US housing market should be a no-brainer. There is sharply declining house price appreciation across all local housing markets and housing indicators such as starts, sales and mortgage applications are all showing declining trends. But try telling that to a CDO manager. These vehicles have been buying so much triple-B home equity loan (HEL) paper that they now account for 80% to 90% of all buyers at this level.

This bullish demand is such that CDOs are now threatening serious disruption to the fundamentals of the HEL market: it doesn’t matter how bad the figures get, there is just one continuous long from CDOs. And it is not as if you can’t express a view. The development of ABS CDS last year was seized upon by macro funds to do just that, and they bought protection on specific names in their droves.

CDO managers seem to be defying fundamentals (and distorting the market) by continuing to pile into subordinated HEL paper and causing spreads to continually grind in. In early May there were record volumes of ABS CDS, with numbers approaching $2.5 billion in one week. This activity is dominated by CDOs selling protection: recent figures from RBS estimate that volumes in triple-B and triple-B minus paper run at between $200 million and $1 billion per week.

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