Collateralized Debt Obligation Market Looks Shaky

The financial press has fretted that the problems in the subprime market may spread to other parts of the mortgage market. While defaults and delinquencies aren’t contagious, investors can get nervous and decide they may have been overly optimistic about risks in safer parts of the market.

But the next likely casualty isn’t higher grade mortgages (except for alt-As which are only marginally better than subprimes). It’s collateralized debt obligations, in part because some of them use subprimes in their structures, and in part because it’s another young industry, and some of its players now appear to have been pretty lax. Many of the underlying loans lacked standard provisions to protect lenders, such as reporting and requirements to maintain certain income and asset levels. Many were also “no documentation” loans, meaning the borrower did not have to provide proof of income or assets.

Delinquencies of 90 days or defaults had reached 10% by year end 2006. The Financial Times has already expressed concern about CDO’s explosive growth, lack of transparency, use of highly leveraged structures, and naivete of some investors (see here and here).

Bloomberg, not prone to sensationalism, has this eye-catching title for an exclusive story: “CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt.” When it rains, it pours.

Bond investors rattled by mounting losses in subprime U.S. mortgages say trouble is brewing in collateralized debt obligations, the same securities that fueled the boom in leveraged buyouts and cut-rate finance.

Sales of CDOs, which package loans, bonds and derivatives into new securities, rose by almost half to $918 billion last year, according to data compiled by JPMorgan Chase & Co. Demand for investments to use in CDOs has helped push risk premiums lower for everything from home loans to high-yield, high-risk bonds, forcing managers to borrow ever more money to maintain returns and stand out from the competition.

“There will ultimately be a shakeout,” said Oliver Wriedt, a partner at New York-based GoldenTree Asset Management LP, which oversees about $8 billion and manages CDOs and was founded in 2000. “Many” new managers “lack the pedigree, or at a minimum the track record. Many have not managed” in a downturn, he said.

Managers of CDOs backed by speculative-grade loans are borrowing as much as 13 times the amount they raise in equity from investors, up from nine to 10 times as recently as late 2005, according to Wriedt. Forty-one percent of the 142 CDOs backed by corporate loans and rated by Moody’s Investors Service last year were set up by first-time issuers.

Potential `Excesses’

“You have a massive supply of loans and new participants,” said Chris Ricciardi, chief executive officer of Cohen & Co. in New York, the biggest issuer of CDOs last year. “There certainly is potential for some excesses and that could turn into some performance issues.”

Cohen has formed 36 CDOs since 2001, including 15 worth a total of $14 billion in 2006, according to Asset-Backed Alert.

CDOs are financing a record number of loans to low-rated borrowers that forgo standard investor protections, such as quarterly limits on the amount of debt relative to earnings. Some $36 billion of the loans were made this year, more than the previous 10 years combined, New York-based Morgan Stanley found.

Individuals with poor credit histories who borrowed for home loans obtained similar easy terms. Many of those subprime loans also have ended up in CDOs.

As of Dec. 31, about 10 percent of subprime loans in securities were either delinquent by at least 90 days, in foreclosure or turned into seized property, the most in at least seven years, according to securities firm Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. Subprime delinquencies overall rose to 13.33 percent last quarter, the Mortgage Bankers Association said today.

`Toxic Waste’

“When you talk about no documentation loans, you can’t have any less of a standard than that,” said Martin Fridson, chief executive officer of high-yield research firm FridsonVision LLC in New York. The lenders “lower their standards and say ‘Well, we can put them into CDOs.’ Like that’s somehow burying that it’s toxic waste.”

About $173 billion of CDOs backed mainly by U.S. subprime mortgage bonds and related derivatives were created last year, according to New York-based JPMorgan…

Investors “need to worry a good bit” about subprime delinquencies spilling over into the CDO market, said Mark Adelson, head of structured finance research at Nomura Securities Inc. in New York. “The scenario where the BBBs all blow up is a reasonably possible scenario,” Adelson said.

CDOs backed by asset-backed securities have already lost about $20 billion in value as delinquencies have increased, according to Lehman Brothers Holdings Inc. data.

Drexel Invention

CDOs were first set up in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk bond king Michael Milken. Junk, or high-yield, debt are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating, and are known as the equity tranches because they are first in line for any losses. Investors in the equity portion expect to generate returns of more than 10 percent…

Buyout firms from Kohlberg Kravis Roberts & Co. to Blackstone Group LP have been among the biggest beneficiaries of CDOs. High-yield, or leveraged, loans financed 57 percent of the record $1.55 trillion of mergers and acquisitions last year, the most in seven years, according to S&P.

`Credit Amnesia’

About $154 billion of CDOs that focus mainly on loans were created in 2006, up from $68.2 billion in 2005, according to data compiled by Morgan Stanley. The demand has allowed companies rated four or five levels below investment-grade to pay just 2.12 percentage points more than benchmark rates this month to borrow, an all-time low, S&P says.

“We think there is a kind of a credit amnesia that is going on,” said William Chew, managing director at S&P in New York. LBO loans the last two years “had a record number of the deals at the lower end of the credit spectrum. That’s the kind of thing which tells us that these are, from a credit risk standpoint, more risky than previous rounds.”

`Trouble May Come’

The increase in new managers is especially dramatic in the market for CDOs backed by loans, said William May, managing director at Moody’s in New York. When defaults increase, an inexperienced manager may have more trouble selling or limiting losses, he said….

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