SAN FRANCISCO (MarketWatch) -- Sales of collateralized debt obligations jumped during the first quarter, but issuance will slow in future amid rising delinquencies in the subprime mortgage business and downgrades of mortgage-backed securities, according to a report on Tuesday by Deutsche Bank.
Collateralized debt obligations (CDOs) are similar to mutual funds, but they usually buy securities that are backed by loans. These complex structures helped fuel the U.S. mortgage boom in recent years by purchasing some of the riskier parts of mortgage-backed securities (MBS) that other investors didn't want.
But delinquencies and defaults have begun to climb on subprime mortgages - home loans that are offered to poorer borrowers with blemished credit records. That's sparked concern that some parts of subprime MBS will be downgraded, triggering losses for investors in the riskier bits of CDOs.
Over the past month, spreads on CDOs have widened considerably. Spreads refer to the difference between yields on riskier assets and interest rates on less risky measures of borrowing, such as the London Interbank Offered Rate (Libor).
Spreads of AA-, A-, BBB- and BB-rated CDOs have widened by 65, 125, 175, and 250 basis points respectively during the past month, Anthony Thompson, head of Global CDO Research at Deutsche Bank Securities, said in a report on the sector. (A basis point is one hundredth of a percentage point).
"Rising delinquencies on subprime collateral and increased mortgage servicer concerns continue to take their toll on the spreads of CDOs backed by subprime residential MBS," he wrote. "Liquidity has also diminished as more investors elect to assess the situation from the sidelines."
But he forecast a slowdown later this year, when downgrades of residential subprime MBS are likely to have a knock-on effect on CDO ratings.
That's important, because CDOs have helped inject cash into the mortgage finance system. Any slowdown could affect the availability of some types of home loans.
Standard & Poor's expects downgrades of some so-called mezzanine parts of structured finance CDOs as early as the second quarter, Patrice Jordan, head of the Global Asset-Backed and Residential Mortgage Group at the rating agency, said last week during a conference call. (Mezzanine parts of CDOs are riskier and lower rated).
Most of the CDOs that are vulnerable to downgrades were issued in 2002 through 2005. These CDOs are less exposed to subprime MBS than CDOs that came out in 2006, she noted.
"It will only be a matter of time before the absolute volume and severity of residential MBS downgrades will negatively affect CDOs," he wrote.
